Bull Put Spread Options Strategy

Submitted by admin on Thu, 11/25/2021 - 20:49

A bull put spread is a low-risk, low-reward strategy that consists of a short put option and a lower-strike long put option.

Description


A bull put spread entails selling one put option and buying another with the same expiration but a lower strike price.
The short put is used to produce money, whilst the long put is used to mitigate assignment risk and protect the investor in the event of a rapid decline.
The investor will always get a premium (credit) when establishing this position due to the link between the two strike prices.


This method includes a perfect balance of risk and profit.
The maximum this spread may earn is the initial net premium, which is most likely if the stock price remains stable or grows.


If the projection is incorrect and the stock falls instead, the approach results in a reduced profit or a loss for the investor.
The long put limits the maximum loss.
It's worth contrasting this technique with the bull call spread.
Once the net cost to carry is factored in, the profit/loss payout profiles are identical.
The main distinction is the cash flow schedule and the possibility of early assignment.


EXAMPLE


1 SPY 400 put short

1 SPY 380 put long


GAIN MAXIMUM


Received a net premium


LOSS MAXIMUM


Net premium obtained for high strike vs. low strike


The bull call spread necessitates a known initial expenditure in exchange for an uncertain ultimate return, whereas the bull put spread generates a known initial cash inflow in exchange for a probable outlay later.

Outlook


During the period of the options, you're looking for an increase in the price of the underlying stock.



While the longer-term forecast is secondary, if an investor is enthusiastic on the stock's future, there is a case to be made for evaluating another option.
To predict when a projected drop would cease and the ultimate rally would begin, meticulous pinpointing would be required.

Summary


A bull put spread is a low-risk, low-reward strategy that consists of a short put option and a lower-strike long put option.
If the stock price stays the same or grows, this spread usually pays off.

Motivation


This spread is started by investors as a strategy to produce income with no risk, or to profit on a gain in the price of the underlying stock, or both.

Variations


Depending on how the strike prices for the long and short positions are chosen, a vertical put spread can be a bullish or bearish strategy.
For the bearish counterpart, see bear put spread.

Maximum Loss


There is a limit to the amount of money that may be lost.
The worst-case scenario is if the stock price at expiry falls below the lower strike.
The investor will be allocated on the short put, which is now deep in the money, and will exercise their long put in that instance.
Buying the stock at the higher strike and selling it at the lower strike is what simultaneous exercise and assignment entails.
The maximum loss is equal to the difference between the strikes minus the credit given when the position was taken.

Maximum Gain


The maximum profit is capped.
At best, the stock will be trading above the higher strike price at expiry.
Both put options expire worthless in this situation, and the investor keeps the credit gained upon taking the position.

Profit/Loss


This strategy's prospective profit and loss are both quite restricted and well-defined.
The initial net credit is the maximum profit that the investor may expect from the strategy.
If the stock falls below the higher (short put) strike, profits begin to fade, and losses peak if the price falls to, or beyond, the lower (long put) strike.
Profits from exercising the long put entirely offset future losses on the short put below the lower strike price.


The maximum revenue potential and maximum risk are determined by how the investor chooses the two strike prices.
The investor can improve the first net premium income by picking a greater short put strike and/or a lower long put strike.

Breakeven


If the stock price is below the upper strike (short put strike) by the amount of the original credit earned at expiration, the strategy breaks even.
In such instance, the long put would be worthless, and the intrinsic value of the short put would be equal to the net credit.


Short put strike - net credit received Equals breakeven

Volatility


All other things being equal, a smidgeon.
Because the strategy includes shorting one put and longing another with the same expiration, volatility movements on the two contracts may partially negate each other.


However, the stock price might fluctuate in such a way that a change in volatility affects one price more than the other.

Time Passes


The passage of time aids the position, but not as much as it would in a simple short put position.
The effects of time decay on the two contracts may negate each other to a substantial degree because the strategy entails being short one put and long another with the same expiration.


Regardless of the theoretical influence of time erosion on the two contracts, it's reasonable to believe that the passage of time is beneficial.
This approach yields net up-front premium income, which is the maximum profit an investor may make.
If there are any claims against it, they must be filed before the expiration date.
As the day of expiration approaches, so does the date when the investor will be free of those responsibilities.

Assignment Danger


Yes.
While early assignment is feasible at any moment, it is most common when a put option is deep into the money.
However, keep in mind that using the long put to cover the short put assignment would need funding a long stock position for one business day.


Also, be aware that if a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, usual expectations for early execution of options on the stock may be entirely thrown off.

Risk of Expiration


Yes.
This method carries additional risk if it is retained until it expires.
Until the Monday after expiry, the investor has no way of knowing whether or not they will be allocated on the short put.
If the stock is trading slightly below, at, or just above the short put strike, the problem is magnified.


Let's say the short put expires slightly in the money, and the investor sells the stock short to avoid getting assigned.
If assignment fails, the investor will not be aware of the unanticipated net short stock position until the following Monday, putting the stock in jeopardy during the weekend.


There is also a chance of guessing incorrectly in the other way.
Assume the investor is betting against getting allocated this time.
If assignment occurs, the investor will have a net long position in a stock that may have lost value over the weekend come Monday.


There are two options for being ready: narrow the spread early or be ready for either outcome on Monday.
In any case, it's critical to keep an eye on the stock, particularly on the last day of trading.