Bull Put Spreads
Bull put spreads are also known put credit spreads. They are a bullish selling options trading strategy that involves selling a put then buying another put with the same expiration date. This combination process enables the options seller to receive a net premium and the seller gets to keep this premium if price expires away from the short strike by expiration.
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What Are Bull Put Spreads?
Bull put spreads are a bullish options strategy. They consist of selling a higher striking in-the-money (ITM) and buying a lower striking out-of-the-money (OTM) thus creating a net credit. If price stays above short strike by expiration then you keep the collected premium (money).
Options are popular because they allow you to make money in any market condition. Therefore, sideways markets can still make you money, or even when the market is correcting. However, there are many moving parts to understand in the world of options.
An options trader will use bull put spreads when they feel the price of a underlying asset will trade sideways, and or will slightly rise in the near future. The bull put spread options strategy has many names. For example, the bull put credit spread, short put spread or a vertical spread.
I must admit, all the different names seem like overkill. However, it’s good to know that they all mean the same thing.
What’s more, creditis received upon entering the trade hence the term credit spread.
Trading credit spreads for a living, how cool is that? They’re pretty simple to build.
I must admit, credit spreads are a pretty good strategy to have in your trading arsenal. Keep reading and I’ll show you how!
Bull Put Spread Example
Building a bull put spread takes two steps. In fact, all spreads strategies require only two steps. Here’s how it looks:
- Sell a higher striking in-the-money (ITM) put option (B) (collect a credit)
- Buy a lower striking out-of-the-money (OTM) put option (A) (caps your loss and gains)
Remember, the options contracts are the same stock with the same expiration date. If the option is assigned with a short put, you’re obligated to buy the stock at strike price B. The right to sell the stock at strike price A is yours, however…
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 trade-off; buying the put also reduces the net credit received when running the strategy.
The premium earned from selling the higher-strike put (B) pays for the cost of buying the lower-strike put (A). You get credited immediately, making this strategy great.
You make money from the difference between the premium paid from each of the options.
Let’s Talk Strategy
Bull put spreads have a strategy. Your end goal here is to have the price of the underlying asset to be either at or above strike price B (the higher strike option) at expiration. Why should this be your end goal? Because this will maximize your profit.
The reason why the option expires worthlessly is that no one would want to exercise it (i.e. sell their shares.) at a strike price lower than the market price.
Further to this, you don’t have to pay any commissions to exit your position. In order to increase your probability of success, have the strike price of B around one standard deviation out-of-the-money when you sell it.
On the other hand, the further out-of-the-money the strike price is, lowers the credit you get from the spread. As a result, keep this in mind when constructing your bull put spreads.
Let’s Talk Time Frame
Bull put spreads work best with an expiration date around 30-45 days from the time of purcahse. Mainly because time decay is on your side – remember you want both options to expire worthlessly.
Don’t forget about implied volatility. However, you can maximize time decay by keeping the expiration date tight.
You must remember that there is a drawback to this strategy, and it comes in the form of missing out on future gains.
Once the stock rises above the upper strike price, the strategy ceases to earn any more profit. If the stock soars in the price – think above strike price B, you’ll miss out. All you’ll get is the initial premium credit.
However, protecting yourself is more important than making a lot of money. You can use more than one strategy to make money.
Bull put spreads protect your account. We’d argue that’s more important than making huge gains with every trade.
Time Decay Is Good With Bull Put Spreads
Time decay and its impacts on an option’s value can’t be stressed enough. A bull put spread is no different.
In fact, time decay is an advantage with this strategy. It’s a huge advantage. Did you know that 80% of options expire worthless? That puts the odds on the side of the put writer (bull put spread originator).
Take advantage of the time decay. It’s one of the few instances in which you can.
A Real Life Example
You’ve done your research, checked out the fundamentals and feel that shares of American Airlines (AAL) are going to rise from their current price of $43. In order to enter bull put spreads, you buy a JUL 40 put ($100) and write “sell” a JUL 45 put for $300.
$200 is the net credit earned by opening a bull put spread. You get $200 by subtracting $300 from $100. Earnings are announced in 25 days. You anticipate positive earnings so you choose an expiration 30 days out.
Shares of AAL rise in price as positive earnings are accounced. Five days later share prices are at $46, and your options expire worthless. End result: you keep the entire $200 as a profit.
On the other hand, if $AAL declines to $38 at expiration time, you will have a net loss. The intrinsic value of the JUL 40 call is $200 whereas the intrinsic value of the JUL 45 call is $500. Your loss is $300 when you do the math.
If there’s a silver lining in this cloud it’s that this is also your maximum possible loss.
How Do You Profit With Bull Put Spreads?
The formula for calculating maximum profit is as follows:
- Max Profit = Net Premium Received – Commissions Paid
- Max Profit Achieved When Price of Underlying >= Strike Price of Short Put (B)
As you can see your maximum profit is the difference from the premium you got for writing the put option and the cost of buying a put option (A). Don’t forget about commissions. The amount depends on the broker.
Your Maximum Loss
You will lose money with this strategy if the stock price is below the upper strike price. It makes sense if you think about it.
The person who bought the put option you sold will now want to sell their shares at the more lucrative strike price. Luckily, you have a buffer in the form of the premium the buyer paid you to cover the loss.
But this luck runs out if the stock price continues to decline. If the stock price falls below the strike price of the lower put option you bought, you’ll lose money. Your maximum loss is realized.
When Should You Run Bull Put Spreads?
Bull put spreads generate income with limited downside. You may also be anticipating neutral activity if strike B is out-of-the-money.
Therefore, a bull put spread makes you money while protecting your brokerage account. Take our advanced options strategies course.
- Loss of money is known up front and therefore capped
- Your brokerage account is protected
- You can make money in choppy markets
- Perfect for traders who have a part time job
- The risk of loss if you have to exit
- This strategy has limited profit potential
- You will miss out on future gains if the stock price rises above the upper strike price
- The risk of early assignment is significant on the short put leg before expiration if the stock slides. As the contract writer, you’ll forced to pay the high price for the stock. And, if the difference is substantial between the two strike prices, the risk of early assignment goes up as well.
Key Takeaways of Bull Put Spreads
- Use this strategy when you expect a moderate rise in the price of the underlying.
- This strategy pays an initial credit and uses two put options to form a range consisting of a high strike price and a low strike price.
- The difference between the strike prices of the two put options and the net credit received is your maximum loss.
- The maximum profit or net credit happens only if the stock’s price closes above the higher strike price at the expiration date.
- Less fomo – let the trade workout (duration over direction)
The Bottom Line
Bull put spreads are an effective strategy when implemented correctly if you want to make money from premiums or buy stocks that are below-market price. The options is of a low-risk nature therefore limiting profits.
Indeed, bull put spreads have limited reward. This isn’t a bad thing for new traders. Although, to the intermediate options trader, it may be limiting.
Every trader needs their own strategy and edge. You need to find your spot in the market where you feel comfortable and Bullish Bears can help you learn options trading. We understand that the process can seem overwhelming, but we want you to succeed! Reach out to us for help if you need it!
If you need more help, take our options trading course.