Understanding Bull Put Spread in Trading: A Comprehensive Guide

Derivatives are preferred by many for portfolio diversification, hedging, risk mitigation, speculation, and other reasons. While you can buy and sell futures and options, there is also room for spreading. You can buy/sell multiple contracts simultaneously to earn from the price spreads. A bull put spread is common among options traders, as it helps minimise risks. Continue reading to understand what is a bull put spread in detail.

What is a Bull Put Spread?

Before understanding a bull put spread in a bull market, you must be familiar with options. An option allows you to buy/sell the underlying asset on a future date, called the expiration date. It is a financial contract with a predetermined price for selling/buying the underlying asset, called the strike price. It is a put option when you get the right but not the obligation to purchase the underlying asset at the strike price. On the other hand, a call option allows you to sell the underlying asset at the strike price.

You can use two put options to create a spread and minimise risks. A bull put spread is created with the help of two put options. You can start by short-selling a put option with a higher strike price. The next step is to purchase a put option with a lower strike price. One of the four common vertical spreads, it allows you to earn from the premium collected on short-selling the put option. The premium collected on short selling the put option is usually more than what you collect on buying the put with a lower strike price.

Example of a Bull Put Spread

Let us take a bull put spread example for clear understanding. Suppose you bought a put option with a strike price of Rs 100. You short-sell another put option with the same expiration date but a strike price of Rs 150. The premium paid for purchasing the put option is Rs 25, while the premium received on short-selling another put option is Rs 60. As a result, you get Rs 35 as a net gain (maximum profit) from the premium collected. The maximum loss in this case would be Rs 85. However, you will only experience a loss when the asset’s market price on the expiration date is less than Rs 115 (breakeven point = strike price of the short put – net premium gain).

Profiting From a Bull Put Spread

Most investors rely on bull put spread to earn steady profits. The premium collected on short-selling a put option with a higher strike price is usually more than what you pay to purchase a put with a lower strike price. When the asset’s market price on the expiration date does not go below the breakeven point, you get to keep the net premium gain. It is crucial to note that the net premium gain is also the maximum profit you can collect with this strategy. However, it is essential to check out the maximum loss you might encounter before making a decision.

Recommended Read: What is a Call Option?

It is perfect for assets showing sideways or marginally higher movement. During sideways movement, it is challenging to tell the market direction. Marginally higher markets see upward price movements but only by a smaller margin. It is one of the effective bullish trading strategies in such markets. The bull put spread strategy can help minimise the risk in choppy markets. You can balance both the put options accordingly to increase the chances of getting the net premium gain, which is also the maximum profit.

Calculations

Now that you have understood the bull put spread strategy, let us get to the calculation part. The maximum profit you can receive is the net premium income. You must subtract the premium paid for purchasing a long put from the premium received on the short put.

You will make no profit and incur no loss at the breakeven point. The formula for the breakeven point in this strategy is as follows:

Breakeven Point = Strike price of the short put – net premium gain

You might also incur a loss with the bull strategy. However, the loss will only occur when the asset’s market price on the expiration date is below the long put’s strike price. Here is the formula for calculating the maximum loss in a bull put spread:

Maximum Loss = (Strike price of long put – strike price of short put) – net premium gain

Note: In the above formula, the negative sign will represent the loss incurred.

Advantages

Here are some pros of this strategy:

  • You will experience loss when the asset’s market price goes below the strike price of the long put. Since this happens occasionally, you have more chances of making a profit.

  • It will help you benefit from the time decay. Most options expire during the given tenure. Some options might not even be exercised.

  • It is perfect for earning premium income by selling a short put . However, you must subtract the premium paid for purchasing the long put to know the net gain.

  • It can also be modified based on one’s risk tolerance. Retail investors might choose narrow spreads to minimise the chances of loss. On the other hand, seasoned investors can go for wider spreads.

Disadvantages

Here are some cons of the bull put spread strategy:

  • The maximum profit is the difference between the premium received and paid. Additionally, your maximum gain is capped.

  • Investors opting for wider spreads might encounter a loss. However, it will happen only when the asset’s market price goes below the strike price of the long put.

  • The strategy works relatively better in markets showing sideways or marginally higher movements. It might not work efficiently in a market where prices are constantly plummeting.

  • The bull put spread strategy might not be ideal when prices rise significantly. In such a case, you must choose a bull call spread to earn returns.

In a Nutshell

The strategy allows you to earn returns when the market shows sideways or marginally higher movements. To implement this strategy, you can short-sell and purchase a put with the same expiration date. However, the short put’s strike price must be higher than that of the long put. It will allow you to collect the net premium gain on both put options. It is the perfect bullish strategy for choppy markets showing unpredictable movements. Implement the bull put spread strategy now!



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