Discover the ins and outs of the bull put spread options strategy, perfect for investors anticipating a moderate rise in an asset’s price. Learn how to execute it, its potential benefits, drawbacks, and real-world examples.
Bull Put Spread: How (and why) to trade this options strategy
If you’re an investor eyeing a moderate rise in an asset’s price, the bull put spread options strategy could be your ace in the hole. This strategy combines two put options, establishing a price range with a higher and lower strike price. Your reward? A net credit formed from the premiums of these options. Let’s dive into the world of bull put spreads and explore how to trade them effectively.
Understanding a bull put spread
Typically, put options are favored by investors expecting a decline in a stock’s price. They provide the right, but not the obligation, to sell a stock at or before the contract’s expiration date. Each put option comes with a strike price, the level at which the option converts into the underlying stock, and requires a premium to purchase.
However, the bull put spread flips this script. It’s designed to profit from a stock’s ascent. If the stock closes above the strike price at expiration, the put option expires as worthless. After all, who would sell their stock at a lower strike price when the market offers a better deal? In this scenario, the investor who bought the put option loses only the premium they paid.
Conversely, the put option seller hopes the stock doesn’t decline but rises above the strike, rendering the put option worthless. The seller pockets the initial premium and aims to keep it. Yet, if the stock falls below the strike, the put seller faces the music. The option holder reaps a profit and exercises their rights, selling their shares at the higher strike price, effectively obliging the put seller. The seller’s premium is reduced depending on how far the stock falls below the put option’s strike.
The bull put spread strategy ensures that even if the stock price dips, the seller retains the premium earned from selling the put option.
Construction of the bull put spread
A bull put spread comprises two put options. Initially, an investor buys one put option and pays a premium. Simultaneously, they sell a second put option with a higher strike price, receiving a premium for the sale. Note that both options share the same expiration date. Given that put options depreciate as the underlying asset appreciates, both options expire worthless if the underlying price finishes higher than the highest strike. Consequently, the maximum profit equals the premium received from writing the spread.
The bull put spread is an excellent tool for bullish investors, offering income potential with limited downside. However, it’s not without its risks.
Here is a list of the benefits and drawbacks to consider.
- Generate income through the initial credit
- Maximum loss is capped and known upfront
- Maximum loss is the difference between strike prices and the net credit
- Limited profit potential, missing out on future gains if the stock exceeds the upper strike price
Example of a bull put spread
Imagine you’re bullish on Apple (AAPL) for the next month, and the stock currently trades at $275 per share. To execute a bull put spread, you:
- Sell one put option with a strike of $280, expiring in one month, for $8.50
- Buy one put option with a strike of $270, expiring in one month, for $2
By doing this, you earn a net credit of $6.50 for the two options ($8.50 credit – $2 premium paid). Since each options contract represents 100 shares of the underlying asset, the total credit received is $650.
Scenario 1: Maximum Profit
If Apple rises and trades at $300 at expiry, you achieve the maximum profit of $650, calculated as ($8.50 – $2) x 100 shares. Once the stock surpasses the upper strike price, no additional profit is possible.
Scenario 2: Maximum Loss
If Apple trades at $270 per share or below the lower strike, the maximum loss is realized. However, the loss is capped at $350, calculated as ($280 put – $270 put – ($8.50 – $2)) x 100 shares.
Your ideal scenario is for the stock to close above $280 per share at expiration, ensuring maximum profit.
Frequently asked questions
What is a bull put spread?
A bull put spread is an options trading strategy used when an investor anticipates a moderate rise in the price of the underlying asset. It involves the simultaneous purchase and sale of put options with different strike prices.
How is a bull put spread constructed?
A bull put spread is constructed by buying one put option with a lower strike price and selling another put option with a higher strike price. Both options have the same expiration date.
What is the maximum profit in a bull put spread?
The maximum profit in a bull put spread is the net credit received when opening the position. This occurs if the stock’s price closes above the higher strike price at expiration.
What is the maximum loss in a bull put spread?
The maximum loss in a bull put spread is the difference between the strike prices of the two put options minus the net credit received initially.
What are the benefits of using a bull put spread?
Using a bull put spread allows investors to generate income through the initial credit received and caps the maximum loss, providing a defined risk-reward profile.
What are the drawbacks of a bull put spread?
One drawback is the limited profit potential, as the strategy misses out on further gains if the stock price exceeds the higher strike price. Additionally, if the stock price falls below the lower strike, losses can occur.
- A bull put spread is an options strategy used for anticipating a moderate rise in the underlying asset’s price.
- It involves buying one put option and selling another with a higher strike price, both expiring on the same date.
- The strategy offers a capped maximum loss and income potential through the initial credit.
- Maximum profit occurs if the stock closes above the higher strike price at expiry.