What are Bull Put Spreads?

A bull put spread is a trading strategy in the options market in which the trader purchases put options at a predetermined strike price while simultaneously selling the same number of put contracts at a higher strike price than the earlier contract. This type of options trading strategy is used when the trader expects the price of the underlying asset being traded to end higher than the previous strike price on expiry. The trader therefore expects to profit from the premium after the contract with the lower strike price expires without value, after transaction costs have been removed.

Another name for the bull put spread is a bull put credit spread because the trader’ account is in credit once the trade is placed, covering even the transaction costs. This is in contrast to trades in a conventional market where transaction costs always put the trade into debit ab initio.

Trade Example

For this example, we will assume that a stock XY is trading at $50, and the trader wants to play the bull put spread on this trade, with ten option contracts. The options trader purchases one bull put spread option contracts at a strike price of $52.5, for a cost of $8 per contract. There are 100 shares per contract, so the cost of the contract is $800.

At the same time, the trader buys one bull put option contract with a strike price of $62.5, for $27 a share, making $2,700 per options contract. The trader’s position will be credited with the difference between the trade cost of the first and second contract ({27 – 8} X 100 shares per contract or 1000 shares), which is $1900.

If the price of this stock closes above $52.5 when the trade expires, the bull put options contract purchased at a strike price of $52.5 will expire worthless while the options contract purchased at a strike price of $62.5 per share will expire in the money, leaving the trader to walk away with the following as profit:

Amount credited to the trader on trade open – transaction costs

(1900 – {(62.5 – 55) X 100 shares})  = $1150

If the price of this stock closes at $50, both trades are out-of-the-money and the trader will lose money on both contracts. The amount initially credited will be deducted from this amount to give his net loss.

There is also a trade outcome where the trade can end at breakeven point, but this is rare. Usually, the trade will end either in a profit or loss for the trader.

 

 

Considerations

As in other options trade types, the trader must analyse the underlying asset to determine its price direction in order to avoid sustaining losses. An appropriate expiry date/time must be set by the trader so that there is just enough time for the asset to respond as the trader wishes.

Thirdly, the trader must keep his trade size to within 5% exposure maximum in conformity with acceptable risk management practices.

If these rules are obeyed, then the trader will go home smiling with some money in the bank.

Recent Posts