This is the part 2 explanation of the 4 Vertical Spread options strategies where I will explain more in-depth my favorite vertical spread strategy for bullish play, which is the Bull PUT Spread Strategy.
The 4 vertical spread strategies are summarised below:
A bull PUT spread is an options strategy that an investor uses when they expect a moderate rise in the price of the underlying asset. The strategy employs two put options to form a range, consisting of a high strike price and a low strike price.
In the previous article, I mentioned that a bullish strategy of using PUT Options is to sell PUT options and thus in this Bull PUT Spread, selling PUT is predominant, which will result in net credit received. In order to have net credit received, the premium received must be greater than the premium paid.
Link to the previous article:
Vertical Spreads Options Strategies Explained For Newbies | A Simple Way To Understand And Remember Vertical Spreads
Using the direct correlation between PUT options premium and strike price, i.e. higher strike price = higher premium and vice-versa, the sell PUT leg will be at a higher strike price (higher premium) than the buy PUT leg (lower premium).
As such, the buy PUT will happen at a lower SP while the sell PUT will happen at a higher SP, as summarized below:
I hope this helps in your understanding and remembering of the Bull PUT Spread. This is a powerful strategy that you can use to long the market when the market is rising or there is an obvious upward trend while avoiding the collateral required to buy 100 shares from a single-legged sell PUT contract.
What Is The Max Gain, Loss & Breakeven?
The Maximum gain of a Bull PUT Spread is the premium that you receive when you open up the contract. This happens when both contracts expire OTM and become worthless.
The Maximum loss of a Bul PUT Spread is the difference of the strike price multiplied by 100 per contract, minus the premium you receive for the contract.
Max Loss = (Difference in SP x 100) – premium received for contract
This is when both contracts expire ITM, thus you have to sell the shares at the lower price and buy the shares at the higher price.
The Breakeven Price is the higher SP – the premium price per share.
Bull PUT Spread Example
Let’s assume Google’s parent company, Alphabet, is currently trading at $100. An option trader expects it to trade up to $103 in one month due to seasonality and mid-term election effect.
While she would like to write (sell) puts on the stock, she is concerned about its potential downside risk and the huge collateral required to sell a cash secured PUT on Alphabet.
The trader therefore writes three contracts of the $100 puts – trading at $3 – expiring in one month, and simultaneously buys three contracts of the $97 puts – trading at $1 – also expiring in one month.
Since each option contract represents 100 shares, the option trader’s net premium income (credit received) is:
($3 x 100 x 3) – ($1 x 100 x 3) = $600
(Commissions are not included in the calculations below for the sake of simplicity.)
Consider the possible scenarios a month from now in the final minutes of trading on the option expiration date:
Scenario 1: Alphabet is trading at $102 (Max Gain)
In this case, the $100 and $97 puts are both out of the money and will expire worthless.
The trader therefore gets to keep the full amount of the $600 net premium (less commissions).
A scenario where the stock trades above the strike price of the short put leg is the best possible scenario for a bull put spread.
Scenario 2: Alphabet is trading at $98 (Breakeven)
In this case, the $100 put is in the money by $2, while the $97 put is out of the money and therefore worthless.
The trader therefore has two choices: (a) close the short put leg at $2, or (b) buy the stock at $100 to fulfill the obligation arising from exercising the short put.
The former course of action is preferable, since the latter would incur additional commissions.
Closing the short put leg at $2 would entail an outlay of $600 (i.e. $2 x 3 contracts x 100 shares per contract). Since the trader received a net credit of $600 when initiating the bull put spread, the overall return is $0.
The trader therefore breaks even on the trade but is out of pocket to the extent of the commissions paid.
Scenario 3: Alphabet is trading at $93 (Max Loss)
In this case, the $100 put is in the money by $7, while the $97 put is in the money by $4.
The loss on this position is therefore: [($7 – $4) x 3 x 100] = $900.
But since the trader received $600 when initiating the bull put spread, the net loss = $600 – $900
= -$300 (plus commissions).
Advantages of a Bull Put Spread
1. Risk is limited to the difference between the strike prices of the short put and long put. This means that there is little risk of the position incurring large losses, as would be the case with puts written on a sliding stock or market.
2. The bull put spread takes advantage of time decay, which is a very potent factor in option strategy. Since most options either expire or go unexercised, the odds are on the side of a put writer or bull put spread originator.
3. The bull put spread can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the put strike prices are not very far apart, as this will reduce the maximum risk as well as the maximum potential gain of the position. An aggressive trader may prefer a wider spread to maximize gains even if it means a bigger loss should the stock decline.
4. Since it is a spread strategy, a bull put spread will have lower margin requirements compared to put writes.
Disadvantages of a Bull Put Spread
1. Gains are limited in this option strategy and may not be enough to justify the risk of loss if the strategy does not work out.
2. There is a significant risk of assignment on the short put leg before expiration, especially if the stock slides. This may result in the trader being forced to pay a price well above the current market price for a stock. This risk is greater if the difference is substantial between the strike prices of the short put and long put in the bull put spread.
3. As noted earlier, a bull put spread works best in markets trading sideways to marginally higher, which means that the range of optimal market conditions for this strategy is quite limited. If markets surge, the trader would be better off buying calls or using a bull call spread; if markets plunge, the bull put spread strategy will generally be unprofitable.
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