Put Spreads Explained

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Bull Put Spread Payoff, Break-Even and R/R

This page explains bull put spread profit and loss at expiration and the calculation of its maximum profit, maximum loss, break-even point and risk-reward ratio.

Bull Put Spread Basic Characteristics

Bull put spread, also known as short put spread, is a position created with two put options:

  • Buying a put with lower strike.
  • Selling a put with higher strike and same expiration.

It is actually the other side of a bear put spread trade, where a higher strike put is bought and a lower strike put is sold. As a result, the profit and loss profile is also inverse. While bear put spread is a bearish strategy, bull put spread as its name suggests is bullish – profits when the underlying security goes up. Like other vertical spreads, a bull put spread has limited risk and limited profit potential.

Unlike bear put spread and unlike bull call spread (which is also bullish and has a similar payoff profile), bull put spread is a credit spread, which means the cash flow when opening the position is positive. This is because the higher strike put that you sell is typically more expensive than the lower strike put that you buy. However, the trade typically comes with margin requirement.

The objective of a bull put spread trade, as with other credit spreads, is to defend the premium that you have received. In an ideal case, the underlying price goes up and ends up above both the put options’ strikes at expiration, making both the options worthless – the overall outcome of the trade is therefore the initial cash received. The worst case scenario is that underlying price ends up below both strikes, resulting in a loss that corresponds to the difference between the two strikes, less premium received.

Let’s illustrate the profit and loss profile on an example.

Bull Put Spread Example

Consider a position made up of two legs (options):

Buy a $45 strike put option for $1.87 per share, or $187 total cost (assuming 100 shares per contract as for standard US equity options).

Sell a $50 strike put for $4.49 per share, or $449 total cash inflow.

Initial cash flow is therefore $449 – $187 = $262, net positive.

Note that this is exactly the other side of the trade we have used for the bear put spread example. This time, we want the underlying price to increase and both the put options to get out of the money. If we hold the position until expiration, there are three possible scenarios.

Scenario 1 (Maximum Loss)

The worst case scenario is that we are wrong and the underlying price goes down, getting below both options’ strikes at expiration (for example $42). Both options are in the money. You will be assigned the higher strike put and lose $50 – $42 = $8 per share, or $800 for one option contract. However, the lower strike put which you have bought acts as a hedge and limits the loss. It is in the money by $3 per share ($45 – $42) and reduces the loss by $300. In total, you lose $500 at expiration (the difference between the two strikes = $5 per share), but you have received $262 in the beginning, so the total loss is $238. Again, note that this trade’s maximum loss scenario is the same as the maximum profit scenario from the bear put spread example, just inverse.

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Maximum loss from a bull put spread trade is equal to difference between strikes minus net premium received. It applies when underlying price ends up at or below the lower strike.

Scenario 2 (Maximum Profit)

The best case scenario is again the inverse of the worst case scenario from the bear put spread example. If underlying price ends up above the higher strike, both options expire worthless and there is zero cash flow at expiration. You still keep the premium received when opening the position ($262), which is the maximum possible profit from this trade.

Maximum profit from a bull put spread is equal to premium received in the beginning. It applies when underlying price ends up above the higher strike and both options expire worthless.

Scenario 3 (Between the Strikes)

If underlying price ends up between the two strikes, only the short higher strike put has some value at expiration. Total profit or loss from the trade is therefore equal to the difference between premium received in the beginning and the higher strike put option’s value at expiration. For example, with underlying price at $47.67, the higher strike put is worth $50 – $47.67 = $2.33 per share = $233. This is less than premium received ($262), therefore total result is positive $29, a small profit.

If the underlying drops further to let’s say $46.50, the higher strike put is now worth $50 – $46.50 = $3.50 per share = $350, which exceeds the premium received in the beginning and turns the trade into a loss.

Profit or loss between the two strikes increases as underlying price goes up. Near the lower strike it approaches maximum loss; near the higher strike it approaches maximum profit.

Bull Put Spread Payoff Diagram

You can see the payoff diagram below. The blue line shows overall bull put spread P/L, the green line is the higher strike short put and the red line is the lower strike long put. X axis shows underlying price, Y axis profit or loss.

Below $45 both options are in the money, but changes in their values exactly offset one another and total P/L is a constant loss.

Between $45 and $50 the lower strike long put is worthless and total P/L grows as underlying price increases as the higher strike short put declines in value (grows in profit).

Above $50 both options are out of the money and total profit equals initial net premium received.

Bull Put Spread Break-Even Point

Because bull put spread is the other side of bear put spread, break-even price is the same – only profit for one side is loss for the other and vice versa.

In our example, the break-even point is at $47.38, which is when the value of the short higher strike put ($50 – $47.38) exactly equals net premium received ($2.62).

More generally, the formula for bull put spread break-even point is:

B/E = higher strike – net premium received

Bull Put Spread Risk-Reward Ratio

Risk-reward ratio in our example is 1 : 262/238 = 1 : 1.10. In other words, maximum possible profit is about 10% higher than maximum possible loss from the trade.

General formulas for bull put spread risk and reward are as follows:

Maximum profit (reward) = net premium received

Maximum loss (risk) = higher strike – lower strike – net premium received

Maximum loss (risk) = B/E – lower strike

Similar Option Strategies

We have already mentioned that bull put spread is the other side of bear put spread.

It has similar payoff to bull call spread. The main difference is that bull call spread uses calls rather than puts and it is a debit spread (negative cash flow on position entry).

Another strategy with similar payoff profile is collar, which contains a lower strike long put (exactly like in a bull put spread), a long position in the underlying security and a short higher strike call (the combined effect of long underlying and short call is the same as the short higher strike put in a bull put spread).

Bull put spread can be considered a hedged version of short (naked) put. The difference is the lower strike long put, which reduced premium received and therefore reduced profit potential, but protects the position from extreme drops in underlying price. Distance between the two strikes determines how conservative or how risky a bull put spread is – the wider the gap, the more risk. In fact, a plain and simple short put can be considered something like a bull put spread where the lower strike is zero.

Bear Put Spread Options Trading Strategy Explained

Published on Thursday, April 19, 2020 | Modified on Wednesday, June 5, 2020

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Bear Put Spread Options Strategy

Strategy Level Advance
Instruments Traded Put
Number of Positions 2
Market View Bearish
Risk Profile Limited
Reward Profile Limited
Breakeven Point Strike Price of Long Put – Net Premium

The Bear Put strategy involves selling a Put Option while simultaneously buying a Put option. Contrary to Bear Call Spread, here you pay the higher premium and receive the lower premium. So there is a net debit in premium. Your risk is capped at the difference in premiums while your profit will be limited to the difference in strike prices of Put Option minus net premiums.

This strategy is used when the trader believes that the price of underlying asset will go down moderately. This strategy is also known as the bear put debit spread as a net debit is taken upon entering the trade.

This strategy has a limited risk as well as limited rewards.

How to use the bear put spread options strategy?

The bear put spread strategy looks like as below for NIFTY which are currently traded at в‚№10400 (NIFTY Spot Price):

Bear Put Spread Orders – NIFTY

Orders NIFTY Strike Price
Buy 1 ITM Put NIFTY18APR10600PE
Sell 1 OTM Put NIFTY18APR10200PE

Suppose NIFTY shares are trading at 10400. If we are expecting the price of NIFTY to go down in near future, we buy 1 ITM NIFTY Put and sell 1 OTM NIFTY put to implement this strategy.

If NIFTY rises, your loss will be the net difference in premiums. If it falls, your profit will be the difference between two strike prices minus the net premium paid.

When to use Bear Put Spread strategy?

The bear call spread options strategy is used when you are bearish in market view. The strategy minimizes your risk in the event of prime movements going against your expectations.

Example

Example 1 – Stock Options:

Let’s take a simple example of a stock trading at в‚№38 (spot price) in June. The option contracts for this stock are available at the premium of:

  • July 40 Put – в‚№3
  • July 35 Put – в‚№1

Lot size: 100 shares in 1 lot

  1. Buy July 40 Put: 100*3 = в‚№300 Paid
  2. Sell July 35 Put: 100*1 = в‚№100 Received

Net debit: в‚№300 – в‚№100 = в‚№200

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№38

  • Buy July 40 Put expires in-the-money with an intrinsic value of (40-38)*100 = в‚№200
  • Sell July 35 Put Expires Worthless
  • Net debit was в‚№200 which was paid as net premium.
  • Total Loss = 200 – 200 (net premium paid) = 0

In this scenario no profit or loss is made.

Scenario 2: Stock price goes up to в‚№42

  • Buy July 40 Put expires worthless
  • Sell July 35 Put expires worthless
  • Net debit was в‚№200 which was paid as net premium.
  • Total Loss = в‚№200 (net premium paid)

In this scenario, we lost total в‚№200 which is also the maximum loss in this strategy.

Scenario 3: Stock price goes down to в‚№34

Same as scenario 1:

  • Buy July 40 Put Expires in-the-money with an intrinsic value of (40-34)*100 = в‚№600
  • Sell July 35 Put Expires in-the-money with an intrinsic value of (34-35)*100 = -в‚№100
  • Net debit was в‚№200 which was paid as net premium.
  • Total Profit = 600 – 100 – 200 (net premium paid) = в‚№300

This в‚№300 is also the maximum profit earned in this strategy.

Example 2 – Bank Nifty

Bear Put Spread Example Bank Nifty
Bank Nifty Spot Price 8900
Bank Nifty Lot Size 25
Bear Put Spread Options Strategy
Strike Price(в‚№) Premium(в‚№) Total Premium Paid(в‚№)
(Premium * lot size 25)
Buy 1 ITM Put 9100 500 12500
Sell 1 OTM Put 8800 400 10000
Net Premium (500-400) 100 2500
Breakeven(в‚№) Strike price of the Long Put – Net Premium
(9100 – 100)
9000
Maximum Possible Loss (в‚№) Net Premium Received * Lot Size
(100)*25
2500
Maximum Possible Loss (в‚№) (Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid) * Lot Size
(9100-8800-100)*25
5000
On Expiry Bank NIFTY closes at Net Payoff from 1 ITM Put Brought (в‚№) @9100 Net Payoff from 1 OTM Put Sold (в‚№) @8800 Net Payoff (в‚№)
8600 0 5000 5000
8800 -5000 10000 5000
9000 -10000 10000 0
9200 -12500 10000 -2500
9400 -12500 10000 -2500

Market View – Bearish

When you are expecting the price of the underlying to moderately drop.

Actions

  • Buy ITM Put Option
  • Sell OTM Put Option

Breakeven Point

Strike Price of Long Put – Net Premium

The breakeven point is achieved when the price of the underlying is equal to strike price of long Put minus net premium.

Risk Profile of Bear Put Spread

Limited

The maximum loss is limited to net premium paid. It occurs when the price of the underlying is less than strike price of long Put..

Max Loss = Net Premium Paid.

Reward Profile of Bear Put Spread

Limited

The maximum profit is achieved when the strike price of short Put is greater than the price of the underlying..

Max Profit = Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid.

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Reference ID: #d0376fd0-7975-11ea-ac8b-050d898db9a5

Options Spreads: Put & Call Combination Strategies

Options Combinations Explained

Table of Contents

Options spreads involve the purchase or sale of two or more options covering the same underlying stock or security (ref).

These options can be puts or calls (or sometimes stock too) and be of different options expiries and strike prices.

Each combination produces a different risk and profitability profile, often best visualised using a profit and loss diagram.

For example a trader may sell one AAPL Jan 540 call and buy one AAPL Jan 560 call, a type of call spread as defined below.

In all such strategies, a trader uses the chosen combinations of puts and calls to make a profit should an forecast outcome occur.

This is usually that the underlying stock moves a particular way – up in the case of the call spread above – but in more complex trades can be an expected movement in volatility, or to take advantage of the passage of time (we will see how later).

There are three main types of basic options strategies:

1. Vertical Call and Put Spreads

So called because options with the same expiry date are quoted on an options chain quote board vertically.

Hence, vertical spreads involve put and call combination where the expiry date is the same, but the strike price is different.

Examples include bull/bear call/put spreads as discussed below, and backspreads discussed separately.

Bull Call Strategy

A Bull Call Spread is a simple option combination used to trade an expected increase in a stock’s price, at minimal risk.

It involves buying an option and selling a call option with a higher strike price; an example of a debit spread where there is a net outlay of funds to put on the trade.

So let’s say that IBM is at $162 at the end of October.

It might be possible to buy a Nov 160 call for $3.50 and sell a Nov 165 call for $1.00, a net cost of $2.50 per contract:

  • Buy IBM Nov 160 Call 3.50
    Sell IBM Nov 165 Call 1.00
    Net Cost: $2.50

Should IBM rise and be above $165 at the end of November the spread would be worth $5, thus doubling the invested amount.

Of course if it is lower, the spread is worth less, with the worst case being if IBM falls below $160, whereby the spread is worthless and all money is lost.

The trade is therefore a risk adjusted ‘bet’ that IBM will rise moderately over the next month.

We’ve covered the bull call spread in more detail here.

Bear Call Strategy

A Bear Call Spread is a similar trade used to trade an expected fall in a stock’s price, at minimal risk. It involves selling a call option and buying another with a higher strike price.

Note that this is a credit spread: ie that we receive money for a trade and, if we are correct and the stock does fall, weget to keep this if both options expire worthless.

So, again, with IBM at $162 we might sell the $160 Nov call and purchase the $165 Nov call (ie the opposite of before).

It might be possible to buy a Nov 160 call for $3.50 and sell a Nov 165 call for $1.00, a net credit of $2.50 per contract. ie:

  • Buy IBM Nov 165 Call 1.00
    Sell IBM Nov 160 Call 3.50
    Net Credit: $2.50

If IBM falls below $160, as hoped, both options expire and we get to keep the $2.50.

However, should IBM rise and be above $160 at the end of November, the spread would have to be bought back at whatever value IBM is above $160. The breakeven point for the trade is $162.50.

The trade expectation is therefore that IBM will fall moderately over the next month.

Bull Put Strategy

The put version of the bear call spread: ie a credit is received for ‘betting’ that stock will move in a particular direction (up, as compared to the bear call spread where the ‘bet’ was for the stock to fall). For example:

  • Buy IBM Nov 155 Put 0.75
    Sell IBM Nov 160 Put 2.00
    Net Credit: $1.25

The full credit is kept if IBM is above $160 at the end of November.

Of course should IBM not be below $160, the spread would expire with some value (equal to the stock price less $160). Hence if this value is more than $1.25 – ie the stock price is above $161.25 – the strategy has lost money.

This $161.15 is the break even point of this trade.

Bear Put Strategy

This is the put version of the bull call spread: ie an amount is paid up front which rises in value should the stock will move in the right particular direction (‘down’, compared to ‘up’ for the bear call spread). For example:

Buy IBM Nov 160 Put 2.00
Sell IBM Nov 155 Put 0.75
Net Cost: $1.25

Should IBM fall below $155 by the end of November, the spread is worth $5 (a significant increase from the original $1.25) investment.

However if the stock is above $158.75, the final value of the spread would be less than the $1.25 paid, and the trade would have made a loss.

We covered the bear put spread in more detail here.

2. Horizontal Call and Put Strategies

So called because of options with different expiries being displayed horizontally on an options chain quote board.

They, therefore, involve buying and selling options with different expiry dates, but the same strike price (and, of course, underlying). A calendar spread, is a good example or horizontal call or put spread (see more here).

3. Diagonal Spreads

These, as the name suggest, are a combination of the two and are complex trades involved options of differening strike prices and expiry dates. An example is the LEAP covered call spread detailed later.

Covered Call

One popular strategy that doesn’t really fall into the above categories is the covered call which involves the purchase of stock and sell of a call option. More details on the covered call are available by clicking here.

Advanced Options Combinations: Complex Put and Call Trades

Options have a lot of advantages; but in order to enjoy those advantages, the right strategy is essential. If traders understand how to use all the trading strategies, they can be successful.

We already been through some basic options combinations; now it’s time to go through some more complex strategies.

In particular we’ll look at some strategies such as the iron condor and butterfly spread (including when to put on and the related options greeks).

Strangle Strategy

This strategy is a neutral one where an out-of-money put and out-of-money call are bought together simultaneously for the same expiration date and asset. It is also called “Long Strangle”.

When Would You Put One On?

When the trader believes that in the near short term, the underlying asset would display volatility, the straddle is apt.

When Does It Make Money?

In this Option strategy, unlimited money is made when the underlying asset makes a volatile move. It could be downwards or upwards, that doesn’t matter.

Profit = Underlying Asset Price (>) Long Call’s Strike Price + Net Premium
Profit = Underlying Asset Price (>) Long Put’s Strike Price – Net Premium

When Does It Lose Money?

The spread loses money when the price of the asset on expiration is between the Options’ strike prices.

Loss = Underlying Asset Price = Between Long Call’s Strike Price and Long Put’s Strike Price

Option Greeks

The Delta is neutral, the gamma is always positive, Theta is worst when asset doesn’t move, and Vega is always positive.

Illustration

Assume that Apple Stock is currently trading around $98. A strangle could be a good strategy if the trader is unsure about the direction in which the stock will go.

So, the trader will buy a 97 put and a 99 call. Let us assume they have the same expiration date and value = $1.65. If the stock rallies past $102.3 (3.3+99), the put would have no value and the call would be in-the-money. If it declines, the put would be ITM and the call would have no value.

Straddle Strategy

This strategy is also called “Long Straddle”. When a put and call are bought for the same asset, with the same expiration date and same strike price, it is called a straddle.

When Would You Put One On?

When the trader believes that in the near short term, the underlying asset will display significant volatility, a straddle strategy is used.

When Does It Make Money?

Money is made by the strategy no matter which direction the underlying asset moves towards. The move has to be pretty strong, though.

Profit = Underlying Asset Price (greater than) Long Call’s Strike Price + Net Premium
Profit = Underlying Asset Price (greater than) Long Put’s Strike Price – Net Premium

When Does It Lose Money?

If the price of the underlying asset during expiration is same as the strike price of the bought call and put, the spread loses money.

Loss = Underlying Asset Price = Long Call/Long Put’s Strike Price

Option Greeks

The Delta is neutral, the Gamma is always positive, Theta rises during expiration, and Vega is always positive.

Illustration

Take a new example and assume that Apple stock is currently around $175. Straddle would be a good strategy if the trader thinks that a huge move would be made on either side. A call and put with the same expiration date as the stock would be bought by the trader. Assume that the 175 Call and the 175 Put cost $10 each. If the stock rallies past $195, the call would be ITM by at least $20 and profits will pour in. If the stock falls below $175, the cost of the straddle would be covered. There is a 50/50 chance of being right about the direction because the cost of the straddle is the maximum loss a trader can incur.

Butterfly

In a butterfly spread strategy, there are three strike prices. Two calls are bought – one ITM and one OTM. Two ATM calls are sold.

When Would You Put One On?

When the trader believes that the rise or fall of the underlying stock would not be a lot by expiration, butterfly spread is the best.

When Does It Make Money?

When the price of the underlying stock does not change at all during expiration, this strategy achieves its maximum profit.

Profit = Underlying Asset Price = Short Calls’ Strike Price

When Does It Lose Money?

When the price of the underlying stock is less than or equal to the strike price ITM long call OR when its price is greater than or equal to the strike price of OTM long call, this spread loses money.

Loss = Underlying Asset Price (lesser than or =) ITM Call Strike Price
Loss = Underlying Asset Price (greater than or =) OTM Call Strike Price

Option Greeks

Delta is always positive, Gamma is lowest at ATM and highest at ITM and OTM, Theta is best when it remains in the profit area, and Vega stays positive as long as the volatility is not too much.

Illustration

Assume that Apple stock is trading at $90. Assume that an 80 call is purchased at $1100, two 90 calls are written at $400 (x2), and a 100 call is purchased at $100. The maximum loss would be the net debit = $400. If the price of Apple at expiration remains the same, the 40 calls and the 50 call would have no value and the profit would be $600. If, however, the stock trades below $80, all the options would be useless. If it trades above $100, the loss from the ITM and OTM calls would be set off by the profit from the ATM calls.

Iron Condor

In this strategy, one OTM put with lower strike is sold after buying one OTM put with strike even lower, and one OTM call with higher strike is sold after buying one OTM call with a strike even higher.

When Would You Put One On?

When the trader believes that low volatility is to be expected, the Iron Condor is chosen.

When Does It Make Money?

When the price of the underlying asset is between the strike prices of the sold call and put, this strategy makes money.

Profit = Underlying Asset Price = Between Short Put Strike Price and Short Call Strike Price

When Does It Lose Money?

The spread loses money when the price of the stock falls below purchased put’s strike price or rises above purchased call’s strike price. Loss can sometimes be greater than profit.

Loss = Underlying Asset Price (greater than or =) Long Call Strike Price
Loss = Underlying Asset Price ( lesser than or =) Long Put Strike Price

Option Greeks

The Delta is neutral, the Theta should stay positive, Gamma shouldn’t be too large, and negative Vega should be minimized.

Illustration

Apple Stock is trading at $45, Iron Condor would be – buying 35 Put at $50, writing 40 Put at $100, writing 50 Call at $100, and buying 55 Call at $50. The net credit ($100) is the maximum profit. If the expiration value is the same, all long and short options would be useless and maximum profit would be realized. If it falls to $35 or rises to $55, only the 40 Long Put would be useful and the maximums loss of $400 would be realized.

The following is dealt with on a separate page:

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