Updated: Nov 29, 2020
BULL PUT SPREAD
Strategy Type: Moderately bullish
# of legs: 2 (Short OTM, higher strike Put + Long OTM, lower strike Put)
Maximum Reward: Premium of short Put - Premium of long Put
Maximum Risk: (Strike price of short Put - Strike price of long Put) - (Premium of short Put - Premium of long Put)
Breakeven Price:Strike price of short Put - (Premium of short Put - Premium of long Put)
Payoff Calculation: Payoff of Long Put+ Payoff of Short Put
Explanation of the Strategy
A Bull Put Spread involves selling a slightly OTM Put option and simultaneously buying an OTM Put option with an even lower strike price. Both the options that are transacted must have the same underlying asset and the same expiration date. This is a moderately bullish strategy that benefits when the price of the underlying either remains sideways or rises moderately until the expiration of the option.The lower strike Put option that has been bought acts as an insurance to the higher strike Put option that has been sold. In case the view of the trader goes wrong and the underlying price declines, the losses will get capped at the lower of the two strike prices. So, a Bull Put Spread can be thought of as writing a naked Put but with downside protection. Because the premium received on selling the higher strike Put is greater than the premium paid on buying the lower strike Put, this is a net credit strategy.
Just like the downside of the strategy is limited, so is the upside. No matter how higher the underlying price rises, the trader will not earn a penny more than what he/she has already received in the form of net credit. While the Put that is sold is slightly OTM, there are no restrictions on the lower strike Put that is bought in terms of how lower it can be as compared to the higher strike Put that has been sold. This depends on the trader and is usually a trade-off between the net credit received and the risk involved in case the view of the trader goes wrong. Generally speaking, the wider the difference between the two strikes, the higher will be the net credit that the trader will receive, but the higher will be the loss in case the underlying price falls to the lower strike price, and vice versa. Meanwhile, the strategy is profitable as long as the underlying price is above the breakeven price and is unprofitable when the underlying price is below the breakeven price.
Benefits of the Strategy
· The lower strike Put that is bought acts as an insurance to the higher strike Put that is sold
· Maximum loss is capped at the lower strike price
· The trader can profit even if the underlying price remains sideways
· If used in correct market conditions, the strategy can be a good source of periodic income
Drawbacks of the Strategy
· Maximum reward is limited to the extent of net credit received
· In case the underlying price rises sharply, there would be an opportunity loss
· In absolute value terms, the risk is usually greater than the reward
· Ensure that the price of the underlying is either sideways or trending moderately higher and is unlikely to fall in the near-term
· Ensure that the options you are transacting are not far away from expiry so that there is not much time left for the underlying price to move against you
· Having said that, also ensure that the options are not too close to expiry so that the net credit received is not too small to compensate for the risk involved
· Be realistic when selecting the strike price of the long Put
· Remember, you would want the underlying price to stay above the higher strike price, in order to earn maximum profit
· Remember that the difference between the two strikes will be a trade-off between risk and the net credit that is received
· Ensure that there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Bull Put Spread
GreekValue is Notes : Delta Positive: The overall Delta is positive at initiation. As a result, the position stands to benefit when the underlying price rises, and vice versa.
Gamma: Negative At initiation, the position Gamma is negative, causing the position Delta to fall as the underlying price rises, and vice versa. However, when the underlying price is below the breakeven price, the position Gamma is positive, which causes the position Delta to rise for a given rise in the underlying price, and vice versa.
VegaNegative: At initiation, the overall Vega is negative, meaning volatility hurts the position as long as the underlying price is above the breakeven price. When the underlying price is below the breakeven price, overall Vega ispositive, meaning volatility will benefit the position.
ThetaPositive: The overall Theta is positive at initiation, meaning time decay benefits the position as long as the underlying price is above the breakeven price. However, when the underlying price is below the breakeven price, Theta is negative, meaning time decayhurts the position.
RhoPositive: The overall Rho is positive at initiation. As a result, rising interest rates benefit the position, and vice versa. However, it must be noted that this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Bull Put Spread
The chartbelow is the payoff chart of a Bull Put Spread. Notice that it is quite similar to that of a Bull Call Spread. However, there are differences between the two. The most noteworthy is that a Bull Put Spread is a net credit strategy, while a Bull Call Spread is a net debit strategy.
Notice above that the spread is unprofitable when the underlying price is to the left of the breakeven price and is profitable when the underlying price is to the right of the breakeven price. Also notice that losses and profits are capped at lower strike and higher strike, respectively. At the time of initiation of the spread, because the higher strike is usually just below the underlying price, the spread is already at the sweetest spot. In other words, at the time of initiation, the strategy is already at its maximum profit potential. Hence, the trader would want the underlying price to either remain as is or rise only moderately going forward. If there is a sharp rise in the price of the underlying, there would be an opportunity loss as the trader would not be able to advantage of that rise.
Example of Bull Put Spread
Mr. ABC is of the opinion that Nifty will maintain a range bound to moderately positive tone in the coming days. He observes strong support at 8000 which he feels would hold for the current expiry. He also feels that Nifty is unlikely to cross 8400-8500 zone in the coming days. Based on his observations, Mr. ABC decides to enter into a Bull Put Spread strategy, wherein he will sell a slightlyOTM 8200 strike Put option at ₹540 and simultaneously buy an OTM 7800 strike Put option at ₹385. Given that he would be paying a premium of ₹385 and receiving a premium of ₹540, the net credit would amount to ₹155. Let us summarize the details below:
· Strike price of long Put = 7800
· Strike price of short Put = 8200
· Long Put premium = ₹385
· Short Put premium = ₹540
· Net Credit = ₹155
· Net Credit (in value terms) = ₹11,625 (155 * 75)
· Breakeven price of the strategy = ₹8,045 (8200 - 155)
· Maximum Risk = ₹18,375 ((8200 - 7800 - 155) * 75)
· Maximum Reward = ₹11,625