Bull Put Spread Explained

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Bull put spread

  • Options strategies
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To profit from neutral to bullish price action in the underlying stock.

Explanation

Example of bull put spread

Sell 1 XYZ 100 put at 3.20
Buy 1 XYZ 95 put at (1.30)
Net credit = 1.90

A bull put spread consists of one short put with a higher strike price and one long put with a lower strike price. Both puts have the same underlying stock and the same expiration date. A bull put spread is established for a net credit (or net amount received) and profits from either a rising stock price or from time erosion or from both. Potential profit is limited to the net premium received less commissions and potential loss is limited if the stock price falls below the strike price of the long put.

Maximum profit

Potential profit is limited to the net premium received less commissions, and this profit is realized if the stock price is at or above the strike price of the short put (higher strike) at expiration and both puts expire worthless.

Maximum risk

The maximum risk is equal to the difference between the strike prices minus the net credit received including commissions. In the example above, the difference between the strike prices is 5.00 (100.00 – 95.00 = 5.00), and the net credit is 1.90 (3.20 – 1.30 = 1.90). The maximum risk, therefore, is 3.10 (5.00 – 1.90 = 3.10) per share less commissions. This maximum risk is realized if the stock price is at or below the strike price of the long put at expiration.

Short puts are generally assigned at expiration when the stock price is below the strike price. However, there is a possibility of early assignment. See below.

Breakeven stock price at expiration

Strike price of short put (higher strike) minus net premium received.

In this example: 100.00 – 1.90 = 98.10

Profit/Loss diagram and table: bull put spread

Short 1 100 put at 3.20
Long 1 95 put at (1.30)
Net credit = 1.90
Stock Price at Expiration Short 100 Put Profit/(Loss) at Expiration Long 95 Put Profit/(Loss) at Expiration Bull Put Spread Profit/(Loss) at Expiration
104 +3.20 (1.30) +1.90
103 +3.20 (1.30) +1.90
102 +3.20 (1.30) +1.90
101 +3.20 (1.30) +1.90
100 +3.20 (1.30) +1.90
99 +2.20 (1.30) +0.90
98 +1.20 (1.30) (0.10)
97 +0.20 (1.30) (1.10)
96 (0.80) (1.30) (2.10)
95 (1.80) (1.30) (3.10)
94 (2.80) (0.30) (3.10)
93 (3.80) +0.70 (3.10)
92 (4.80) +1.70 (3.10)

Appropriate market forecast

A bull put spread earns the maximum profit when the price of the underlying stock is above the strike price of the short put (higher strike price) at expiration. Therefore, the ideal forecast is “neutral to bullish price action.”

Strategy discussion

The bull put spreads is a strategy that “collects option premium and limits risk at the same time.” They profit from both time decay and rising stock prices. A bull put spread is the strategy of choice when the forecast is for neutral to rising prices and there is a desire to limit risk.

Impact of stock price change

A bull put spread benefits when the underlying price rises and is hurt when it falls. This means that the position has a “net positive delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bull put spread consists of one short put and one long put, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bull put spread consists of one short put and one long put, the price of a bull put spread changes very little when volatility changes and other factors remain constant. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Since a bull put spread consists of one short put and one long put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or above the strike price of the short put (higher strike price), then the price of the bull put spread decreases (and makes money) with passing of time. This happens because the short put is closest to the money and erodes faster than the long put. However, if the stock price is “close to” or below the strike price of the long put (lower strike price), then the price of the bull put spread increases (and loses money) with passing time. This happens because the long put is now closer to the money and erodes faster than the short put. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull put spread, because both the short put and the long put erode at approximately the same rate.

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Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of a short stock option position have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put (lower strike) in a bull put spread has no risk of early assignment, the short put (higher strike) does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bull put spread (the higher strike), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by buying the short put to close and selling the long put to close. Alternatively, the short put can be purchased to close and the long put open can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put. Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or above the higher strike price, below the higher strike price but not below the lower strike price or below the lower strike price. If the stock price is at or above the higher strike price, then both puts in a bull put spread expire worthless and no stock position is created. If the stock price is below the higher strike price but not below the lower strike price, then the short put is assigned and a long stock position is created. If the stock price is below the lower strike price, then the short put is assigned and the long put is exercised. The result is that stock is purchased at the higher strike price and sold at the lower strike price and the result is no stock position.

Other considerations

The “bull put spread” strategy has other names. It is also known as a “credit put spread” and as a “short put spread.” The term “bull” refers to the fact that the strategy profits with bullish, or rising, stock prices. The term “credit” refers to the fact that the strategy is created for a net credit, or net amount received. Finally, the term “short” refers to the fact that this strategy involves the net selling of options, which is another way of saying that it is established for a net credit.

Short Put Spread

AKA Bull Put Spread; Vertical Spread

The Strategy

A short put spread obligates you to buy the stock at strike price B if the option is assigned but gives you the right to sell stock at strike price A.

A short put spread is an alternative to the short put. In addition to selling a put with strike B, you’re buying the cheaper put with strike A to limit your risk if the stock goes down. But there’s a tradeoff — buying the put also reduces the net credit received when running the strategy.

Options Guy’s Tips

One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.

You may wish to consider ensuring that strike B is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this spread.

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

The Setup

  • Buy a put, strike price A
  • Sell a put, strike price B
  • Generally, the stock will be above strike B

NOTE: Both options have the same expiration month.

Who Should Run It

Seasoned Veterans and higher

When to Run It

You’re bullish. You may also be anticipating neutral activity if strike B is out-of-the-money.

Break-even at Expiration

Strike B minus the net credit received when selling the spread.

The Sweet Spot

You want the stock to be at or above strike B at expiration, so both options will expire worthless.

Maximum Potential Profit

Potential profit is limited to the net credit you receive when you set up the strategy.

Maximum Potential Loss

Risk is limited to the difference between strike A and strike B, minus the net credit received.

Ally Invest Margin Requirement

Margin requirement is the difference between the strike prices.

NOTE: The net credit received when establishing the short put spread may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points and evaluate how your strategy might change as expiration approaches, depending on the Greeks.
  • Use the Technical Analysis Tool to look for bullish indicators.
  • Use the Probability Calculator to verify that strike B is about one standard deviation out-of-the-money.

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Options Spreads Explained – A Complete Guide

Every options trader should know what options spreads are and what different types of options spreads exist. If you aren’t completely familiar with options spreads, this article will definitely help you out! After reading this article, you won’t only know what an options spread is. You will also be familiarized with all the different options spreads that exist. This is very powerful because if you fully understand options spreads, you will understand ALL options strategies!

So without further ado, let’s get started.

What Is An Option Spread?

Before we get into the different kinds of options spreads that exist, it is important to understand what an options spread even is. So what is an option spread?

An options spread is an option strategy involving the purchase and sale of options at different strike prices and/or different expiration dates on one underlying asset. An options spread consists of one type of option only. This means that options spreads either solely consist of call or put options, not both. Furthermore, an options spread has the same number of long as short options.

Let me give you a concrete example to make it clear what an options spread is. The following position is an options spread:

  • 1 XYZ short call with a strike price of 100 that expires in 40 days.
  • 1 XYZ long call with a strike price of 105 that expires in 40 days.

As you can see, the just-described options only differ in regards to strike price and opening transaction (one call option is bought and the other one is sold).

Let’s recap the characteristics of an options spread:

  • All involved options are on the same underlying asset (e.g. XYZ).
  • All involved options are of the same type (call or put).
  • An options spread always consists of the same number of purchased as sold options (e.g. 5 short and 5 long).

In other words, the options involved in an options spread only differ in regards to strike price and/or expiration date. This is the case for all options spreads, regardless of kind. So when I will walk you through all the different options spreads in a few moments, keep this in mind.

Even though the options involved in an options spread only differ in regards to 1-2 aspects, it is still possible to create a wide variety of different options spreads.

Next up, I will walk you through all the different kinds of options spreads: vertical spreads, horizontal spreads, diagonal spreads, credit spreads, debit spreads, bull spreads…

Option Spreads Visually Explained

Watch the following video for a visual breakdown of option spreads:

Different types of options spreads explained

What are vertical spreads?

Vertical spreads are options spreads created with options that only differ in regards to strike price. So basically, a vertical spread consists of the same number of short calls as long calls or the same number of long puts as short puts with the same expiration date (on the same underlying asset).

This doesn’t leave too many possibilities. That is also why only four different vertical spreads exist, namely bull call spreads, bear call spreads, bull put spreads and bear put spreads.

These four different vertical spreads can be ordered into different categories:

  • Bull Spreads: Bullish spreads (that profit from increases in the underlying asset’s price).
  • Bear Spreads: Bearish spreads (that profit from decreases in the underlying asset’s price).
  • Call Spreads: Spreads that consist of call options only.
  • Put Spreads: Spreads that consist of put options only.
  • Credit Spreads: Spreads that are opened for a credit (you get paid to open).
  • Debit Spreads: Spreads that are opened for a debit (you pay to open).

A bull call spread is a bullish debit spread, whereas a bear call spread is a bearish credit spread. A bull put spread is a bullish credit spread and a bear put spread is a bearish debit spread.

Here is how the four different vertical spreads are set up:

Bull Call Spread (aka. Long Call Spread):

  • 1 long call
  • 1 short call at a higher strike price (with the same expiration date)

Bear Call Spread (aka. Short Call Spread):

  • 1 short call
  • 1 long call at a higher strike price (with the same expiration date)

Bull Put Spread (aka. Short Put Spread):

  • 1 long put
  • 1 short put at a higher strike price (with the same expiration date)

Bear Put Spread (aka. Long Put Spread):

  • 1 short put
  • 1 long put at a higher strike price (with the same expiration date)

All vertical spreads are defined risk and defined profit strategies which means that you can’t lose or profit more than a certain amount. The amount of risk and potential profit depends on the width of the strikes and on the position of the strikes in relation to the underlying’s price.

To calculate the max risk and max profit of vertical spreads, you need one calculation:

Width of Strikes × 100 − Net Credit or Debit

This calculation reveals the max risk of credit spreads (Bull Put Spreads and Bear Call Spreads) and the max profit of debit spreads (Bear Put Spreads and Bull Call Spreads).

The max profit of credit spreads equals the net credit collected to open, whereas the max risk of debit spreads equals the net debit paid to open.

Vertical spreads are directional strategies which means that they mainly profit from price movement in the underlying asset’s price. That’s also why they are called bull/bear spreads. This means that vertical spreads are a strategy principally used to take advantage of price movement. Nevertheless, implied volatility and time still can influence vertical spreads to a certain extent.

What are horizontal spreads?

Horizontal spreads are options strategies that consist of the same number of long as short options that only differ in regards to the expiration date (on the same underlying asset). In other words, the options involved have the same strike price but a different expiration date.

Let me give you a concrete example to explain what a horizontal spread is:

  • 1 long ABC call with a strike price of 50 that expires in 29 days (front-month).
  • 1 short ABC call with a strike price of 50 that expires in 57 days (back-month).

Just like with vertical spreads, there only exist four different kinds of horizontal spreads, namely short call calendar spreads, long call calendar spreads, short put calendar spreads and long put calendar spreads. As you may have noticed, all of these spreads are calendar spreads. That is also the reason why horizontal spreads also are referred to as calendar spreads.

The setup of these four different calendar spreads is relatively simple:

Long Call Calendar Spread:

  • 1 short call (front-month)
  • 1 long call at the same strike price (back-month)

Short Call Calendar Spread:

  • 1 long call (front-month)
  • 1 short call at the same strike price (back-month)

Long Put Calendar Spread:

  • 1 short put (front-month)
  • 1 long put at the same strike price (back-month)

Short Put Calendar Spread:

  • 1 long put (front-month)
  • 1 short put at the same strike price (back-month)

Calendar spreads are mainly used as a strategy to profit from changes in implied volatility and from time decay. For instance, long calendar spreads profit from increases in implied volatility.

Generally, calendar spreads aren’t a very directional strategy. But depending on the strike selection, calendar spreads can be set up more and less directional.

What are diagonal spreads?

Diagonal spreads are a combination of vertical and horizontal spreads. A diagonal spread is a strategy that consists of the same number of long as short options that have different strike prices and different expiration dates.

The options used in vertical spreads only differ in regards to strike price, the options used in horizontal spreads only differ in regards to the expiration date and the options used in diagonal spreads differ in regards to both strike price and the expiration date.

There are many different ways to set up diagonal spreads. But here are a few concrete examples of possible diagonal spreads.

Diagonal spread example 1:

  • 1 short XYZ call with a strike price of 185 that expires in 27 days (front-month).
  • 1 long XYZ call with a strike price of 190 that expires in 55 days (back-month).

Diagonal spread example 2:

  • 1 long ABC put with a strike price of 78 that expires in 20 days (front-month).
  • 1 short ABC put with a strike price of 72 that expires in 48 days (back-month).

Just like I said before, diagonal spreads are a combination of vertical and horizontal spreads. This means that they try to profit from changes in both the underlying asset’s price and implied volatility/time. Diagonal spreads can be slightly to very directional strategies.

Recap – Options Spreads Explained

It is very important to understand what an options spread is and what different kinds of spreads exist. That’s why I want to recap some of the most important points of this article.

I created the following table to visually explain the different options spreads. Furthermore, this table actually reveals why the different spreads are called the way that they are (horizontal, vertical, diagonal).

Now you should know what different spreads exist. But you might ask yourself the question, which of these spreads is best.

There is no one right answer to this question. Not one spread is better than another. It really depends on the current market situation and on personal preferences. For instance, if you are bullish on a stock and want to take advantage of an up-move, a bull call vertical spread might be a good strategy. However, if you want to profit from a rise in implied volatility and don’t have a certain directional assumption, a horizontal/calendar spread would probably be a better choice…

I hope you understand what I am trying to say.

But generally speaking, vertical spreads are the simplest of the three. Horizontal and especially diagonal spreads are much more complex due to the different expiration dates of the different options. Therefore, I wouldn’t necessarily recommend trading (horizontal or) diagonal spreads if you aren’t completely familiar with them.

In the introduction, I mentioned that if you fully understand options spreads, you will understand all options strategies. But why do I think this?

The reason why I am saying this is that options spreads are the building blocks of almost all other options strategies. If you combine multiple options spreads, you can create almost any strategy. So instead of trying to understand how these dozens of different strategies work, it is much more efficient to learn how the building blocks of these strategies work.

Let me give you a few examples:

You probably realized that vertical spreads are relatively simple (compared to other options strategies). They are a two-leg strategy that consists of a long call and short call or a long put and short put.

But what happens if we combine multiple vertical spreads?

A new strategy is born! There are four different vertical spreads that can be combined to create a new strategy. I will now give you some concrete examples of what happens when you combine multiple vertical spreads.

Iron Condor

You may or may not know the option strategy iron condors. It is a very good and popular four-leg options strategy. Due to its four legs, it is usually labeled as an ‘advanced’ options strategy. But in reality, it isn’t anything else than a combination of two simple credit spreads.

I created the following image to explain this concept visually.

Hopefully, you can see how a combination of a bear call spread and a bull put spread create an iron condor.

Butterflies

Now let me give you another concrete example. Butterflies are another options strategy often referred to as complex and thus, only suitable for ‘advanced’ traders. But just like with iron condors, butterflies aren’t very complicated either. They are simply a combination of a bear call spread and a bull call spread.

Hopefully, these two examples make it clear how options spreads are the building blocks of most options strategies. These were just two of many examples where this is the case.

So in conclusion, options spreads can be thought of as Lego bricks. Just like Legos, options spreads can be combined in many different ways to create whatever your heart desires.

If you want to learn more about options strategies and when to use which strategies, you might want to check out my free strategy selection handbook.

My goal with this article was to introduce you to options spreads and thereby build a stable foundation for options trading strategies. It would be awesome of you to let me know if I achieved this goal in the comment section below!

Furthermore, if you have any questions, feedback or other comments, please tell me in the comment section.

10 Replies to “Options Spreads Explained – A Complete Guide”

Your explanation of the Option Spreads as building blocks to other strategies makes sense, but I am confused by the Iron Condor and Butterfly.

Does the Iron Condor and Butterfly make you money if the underlying asset price does not go over a certain amount or go over and then come back down before expiration?

That’s kind of what it looks like from looking at the graphs you included.

Thanks for your question. Iron condors and butterflies profit if the underlying asset’s price stays in a certain range. The size of this range depends on the strikes selected and the premium received/paid. I hope this helps with clarifying the confusion.

Otherwise, you could check out my article on Iron Condors and Butterflies.

Reading through this very comprehensive article on Option Spreads in Trading was so interesting. For someone new to this world of Trading it would need to be gone through a few times to fully understand all the terminology and nuances of trading. It is really complex for an ordinary person not versed in doing anything like this previously.

To my mind, if you are ready to Trade, you would need to be aware of the risks involved and not be afraid of losses. Only Trade with the amount you can afford, would be my way of thinking. Perhaps am too conservative.

It was very interesting to learn something new. Will take a look at it again at a later stage.

Thanks for the comment Jill. It is completely normal for people new to the world of trading to have trouble understanding everything. That’s actually also why I created a free trading terminology handbook in which you can look up all the seemingly complicated trading terms. So judging from your comment, you could definitely use my free trading glossary.

And no you are not too conservative! You should never risk more than you can afford to lose.

Hi Louis, I have completed your education classes and they are good, and I have learnt a lot. Best of all, I have learnt more from your free education than all the other programs I have paid for. Be leave me I have spent a lot of money on paid sites and it is not worth it. Selling short term options is my goal. However, I am have trouble comprehending receiving a credit when I sell an option. When I sell an option for a credit, I only receive the credit if it expires worthless Right. Thanks for your help

Hi Tom,
Thanks for the question. I hope I can clarify your confusion. When you sell an option to open a position, you receive a credit. So now you have a negative position open. To close this position, you could either buy back the sold option or wait until expiration. If you buy it back, you will give up some of the received credit. The amount of credit that you give back depends on the option’s price. If it has gone up, you might even have to pay more to close the position than you received when opening it.
If at expiration, the underlying’s price is at the right point, the option might expire worthless and only then, you could keep the entire credit that you collected when putting on the position.

Let me give you a concrete example:
You sell a call option with a strike price of $105 on XYZ which is trading at $100. You receive a credit of $1,50 (so $150). But now you have an open position which has to be closed for you to lock in the profit. As long as the position is open, the profits (or losses) are purely paper profits (or losses). They are only realized if you close the position which you can do by buying back the call option or by waiting until the expiration date.
Let’s say, you buy back the call option for $0,7 two weeks later. This would mean that you have a realized profit of $1,5 – $0,7 = $0,8 (or $80). So you can keep $80 of the collected credit.
If you instead wait until expiration and XYZ’s price is still below $105, you can keep the entire $150 of credit.

I really hope this helps. If you have any other follow-up questions, let me know.

Hi Louis,
In your reply to Tom looks like you did not mention that at expirations time if the stock price is above the strike price in a short call or below the strike price in short put, he would be forced to buy the stock at the strike price.

Thanks for the comment. Usually, when a trade such as a short call or short put is ITM shortly before expiration, I recommend closing the position for a loss. If you do this, you won’t have to buy or sell any shares at the strike price. I never recommend holding a losing short option position into expiration (unless you want to buy or sell stock at the strike price).
But you are right that if you would hold such a position into expiration, you would have to buy/sell stock at the strike price.

since a call spread would probably be assigned if the stock price goes above the strike price, it seems to me that it would be better to use a put spread when one expects the stock to go up and a call spread when one expects it to go down. Opposite of single options.

Hi and thanks for your comment,
I wouldn’t use assignment risk as a main factor when choosing which strategy to go for. Instead, I recommend looking at different market variables such as implied volatility, time till expiration, underlying asset, and price. Depending on the situation and your market assumption, a bull put spread can be better than a bull call spread and vice versa. The same goes for bear spreads. It depends on the situation.

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Bull Put Spread

3.1 – Why Bull Put Spread?

Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked when the view on the market is ‘moderately bullish’. The Bull Put Spread is similar to the Bull Call Spread in terms of the payoff structure; however there are a few differences in terms of strategy execution and strike selection. The bull put spread involves creating a spread by employing ‘Put options’ rather than ‘Call options’ (as is the case in bull call spread).

You may have a fundamental question at this stage – when the payoffs from both Bull call spread and Bull Put spread are similar, why should one choose a certain strategy over the other?

Well, this really depends on how attractive the premiums are. While the Bull Call spread is executed for a debit, the bull put spread is executed for a credit. So if you are at a point in the market where –

  1. The markets have declined considerably (therefore PUT premiums have swelled)
  2. The volatility is on the higher side
  3. There is plenty of time to expiry

And you have a moderately bullish outlook looking ahead, then it makes sense to invoke a Bull Put Spread for a net credit as opposed to invoking a Bull Call Spread for a net debit. Personally I do prefer strategies which offer net credit rather than strategies which offer net debit.

3.2 – Strategy Notes

The bull put spread is a two leg spread strategy traditionally involving ITM and OTM Put options. However you can create the spread using other strikes as well.

To implement the bull put spread –

  1. Buy 1 OTM Put option (leg 1)
  2. Sell 1 ITM Put option (leg 2)

When you do this ensure –

  1. All strikes belong to the same underlying
  2. Belong to the same expiry series
  3. Each leg involves the same number of options

Date – 7 th December 2020

Outlook – Moderately bullish (expect the market to go higher)

Nifty Spot – 7805

Bull Put Spread, trade set up –

  1. Buy 7700 PE by paying Rs.72/- as premium; do note this is an OTM option. Since money is going out of my account this is a debit transaction
  2. Sell 7900 PE and receive Rs.163/- as premium, do note this is an ITM option. Since I receive money, this is a credit transaction
  3. The net cash flow is the difference between the debit and credit i.e 163 – 72 = +91, since this is a positive cashflow, there is a net credit to my account.

Generally speaking in a bull put spread there is always a ‘net credit’, hence the bull put spread is also called referred to as a ‘Credit spread’.

After we initiate the trade, the market can move in any direction and expiry at any level. Therefore let us take up a few scenarios to get a sense of what would happen to the bull put spread for different levels of expiry.

Scenario 1 – Market expires at 7600 (below the lower strike price i.e OTM option)

The value of the Put options at expiry depends upon its intrinsic value. If you recall from the previous module, the intrinsic value of a put option upon expiry is –

Max [Strike-Spot, o]

In case of 7700 PE, the intrinsic value would be –

Max [7700 – 7600 – 0]

Since we are long on the 7700 PE by paying a premium of Rs.72, we would make

= Intrinsic Value – Premium Paid

Likewise, in case of the 7900 PE option it has an intrinsic value of 300, but since we have sold/written this option at Rs.163

Payoff from 7900 PE this would be –

= – 137

Overall strategy payoff would be –

Scenario 2 – Market expires at 7700 (at the lower strike price i.e the OTM option)

The 7700 PE will not have any intrinsic value, hence we will lose all the premium that we have paid i.e Rs.72.

The 7900 PE’s intrinsic value will be Rs.200.

Net Payoff from the strategy would be –

Premium received from selling 7900PE – Intrinsic value of 7900 PE – Premium lost on 7700 PE

Scenario 3 – Market expires at 7900 (at the higher strike price, i.e ITM option)

The intrinsic value of both 7700 PE and 7900 PE would be 0, hence both the potions would expire worthless.

Net Payoff from the strategy would be –

Premium received for 7900 PE – Premium Paid for 7700 PE

= + 91

Scenario 4 – Market expires at 8000 (above the higher strike price, i.e the ITM option)

Both the options i.e 7700 PE and 7900 PE would expire worthless, hence the total strategy payoff would be

Premium received for 7900 PE – Premium Paid for 7700 PE

= + 91

Market Expiry 7700 PE (intrinsic value) 7900 PE (intrinsic value) Net pay off
7600 100 300 -109
7700 0 200 -109
7900 0 0 91
8000 0 0 91

From this analysis, 3 things should be clear to you –

  1. The strategy is profitable as and when the market moves higher
  2. Irrespective of the down move in the market, the loss is restricted to Rs.109, the maximum loss also happens to be the difference between “Spread and net credit’ of the strategy
  3. The maximum profit is capped to 91. This also happens to be the net credit of the strategy.

We can define the ‘Spread’ as –

Spread = Difference between the higher and lower strike price

We can calculate the overall profitability of the strategy for any given expiry value. Here is screenshot of the calculations that I made on the excel sheet –

  • LS – IV — Lower Strike – Intrinsic value (7700 PE, OTM)
  • PP — Premium Paid
  • LS Payoff — Lower Strike Payoff
  • HS-IV — Higher strike – Intrinsic Value (7900 PE, ITM)
  • PR — Premium Received
  • HS Payoff — Higher Strike Payoff

As you can notice, the loss is restricted to Rs.109, and the profit is capped to Rs.91. Given this, we can generalize the Bull Put Spread to identify the Max loss and Max profit levels as –

Bull PUT Spread Max loss = Spread – Net Credit

Net Credit = Premium Received for higher strike – Premium Paid for lower strike

Bull Put Spread Max Profit = Net Credit

This is how the pay off diagram of the Bull Put Spread looks like –

There are three important points to note from the payoff diagram –

  1. The strategy makes a loss if Nifty expires below 7700. However the loss is restricted to Rs.109.
  2. The breakeven point (where the strategy neither make a profit or loss) is achieved when the market expires at 7809. Therefore we can generalize the breakeven point for a Bull Put spread as Higher Strike – Net Credit
  3. The strategy makes money if the market moves above 7809, however the maximum profit achievable is Rs.91 i.e the difference between the Premium Received for ITM PE and the Premium Paid for the OTM PE
    1. Premium Paid for 7700 PE = 72
    2. Premium Received for 7900 PE = 163
    3. Net Credit = 163 – 72 = 91

3.3 – Other Strike combinations

Remember the spread is defined as the difference between the two strike prices. The Bull Put Spread is always created with 1 OTM Put and 1 ITM Put option, however the strikes that you choose can be any OTM and any ITM strike. The further these strikes are the larger the spread, the larger the spread the larger is possible reward.

Let us take some examples considering spot is at 7612 –

Bull Put spread with 7500 PE (OTM) and 7700 PE (ITM)

Lower Strike (OTM, Long) 7500
Higher Strike (ITM, short) 7700
Spread 7700 – 7500 = 200
Lower Strike Premium Paid 62
Higher Strike Premium Received 137
Net Credit 137 – 62 = 75
Max Loss (Spread – Net Credit) 200 – 75 = 125
Max Profit (Net Credit) 75
Breakeven (Higher Strike – Net Credit) 7700 – 75 = 7625

Bull Put spread with 7400 PE (OTM) and 7800 PE (ITM)

Lower Strike (OTM, Long) 7400
Higher Strike (ITM, short) 7800
Spread 7800 – 7400 = 400
Lower Strike Premium Paid 40
Higher Strike Premium Received 198
Net Credit 198 – 40 = 158
Max Loss (Spread – Net Credit) 400 – 158 = 242
Max Profit (Net Credit) 158
Breakeven (Higher Strike – Net Credit) 7800 – 158 = 7642

Bull Put spread with 7500 PE (OTM) and 7800 PE (ITM)

Lower Strike (OTM, Long) 7500
Higher Strike (ITM, short) 7800
Spread 7800 – 7500 = 300
Lower Strike Premium Paid 62
Higher Strike Premium Received 198
Net Credit 198 – 62 = 136
Max Loss (Spread – Net Credit) 300 – 136 = 164
Max Profit (Net Credit) 136
Breakeven (Higher Strike – Net Credit) 7800 – 136 = 7664

So the point here is that, you can create the spread with any combination of OTM and ITM option. However based on the strikes that you choose (and therefore the spread you create), the risk reward ratio changes. In general, if you have a high conviction on a ‘moderately bullish’ view then go ahead and create a larger spread; else stick to a smaller spread.

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