What Is a Bull Put Spread?
A bull put spread is an options strategy that is used when the investor expects a moderate rise in the price of the underlying asset. The strategy uses two put options to form a range consisting of a high strike price and a low strike price. The investor receives a net credit from the difference between the two premiums from the options.
The Bull Put Spread Explained
Put options are typically employed by investors to profit from declines in a stock's price since a put option gives an investor the power—not the requirement—to sell a stock at the expiration date of the contract. Each put option has a strike price, which is the price at which the option converts to the underlying stock at expiry. An investor would pay a premium to purchase a put option.
- A bull put spread is an options strategy that is used when the investor expects a moderate rise in the price of the underlying asset.
- The strategy pays a credit initially and uses two put options to form a range consisting of a high strike price and a low strike price.
- The maximum loss is equal to the difference between the strike prices and the net credit received.
- The maximum profit, which is the net credit only occurs if the stock's price closes above the higher strike price at expiry.
Profits and Loss from Put Options
Put options are typically used by investors who are bearish on a stock, meaning they hope the stock's price declines below the option's strike. However, the bull put spread is designed to benefit if the stock's price rises. If the stock is trading above the strike at expiry, the option expires worthless since no one would sell the stock at a strike price that's lower than the market price. As a result, the buyer of the put loses the value of the premium paid.
On the other hand, an investor who sells a put option is hoping the stock doesn't decrease but instead, rises above the strike so that the put option becomes worthless at expiry. A put option seller—the option writer—receives the premium for selling the option initially and wants to keep that sum. However, if the stock declines below the strike, the seller is on the hook. The option holder has a profit and will exercise their rights, selling their shares at the higher strike price. In other words, the put option is exercised against the seller.
The premium received by the seller would be reduced depending on how far the stock price falls below the put option's strike. The bull put spread is designed to allow the seller to keep the premium earned from selling the put option even if the stock's price declines.
Construction of Bull Put Spread
A bull put spread consists of two put options. First, an investor buys a put option and pays a premium. Next, the investor sells a put option at a higher strike price than the purchased put receiving a premium. Both options have the same expiration date.
The premium earned from selling the higher-strike put exceeds the price paid for the lower-strike put. The investor receives an account credit of the net difference of the premiums from the two put options at the onset of the trade. Investors who are bullish on an underlying stock could use a bull put spread to generate income with limited downside. However, there is a risk of loss with this strategy.
Bull Put Profit and Loss
The maximum profit for a bull put spread is equal to the difference between the amount received from the sold put and the amount paid for the purchased put. In other words, the net credit received initially is the maximum profit, which only happens if the stock's price closes above the higher strike price at expiry.
The goal of the bull put spread strategy is realized when the price of the underlying moves or stays above the higher strike price. The result is the sold option expires worthless. The reason it expires worthless is that no one would want to exercise it and sell their shares at the strike price if it's lower than the market price.
A drawback to the strategy is that it limits the profit earned if the stock rises well above the upper strike price of the sold put option. The investor would pocket the initial credit but miss out on any future gains.
If the stock is below the upper strike in the strategy, the investor will begin to lose money since the put option will likely be exercised. Someone in the market would want to sell their shares at this, more attractive, strike price.
However, the investor received a net credit for the strategy at the outset. This credit provides some cushion for the losses. Once the stock declines far enough to wipe out the credit received, the investor begins losing money on the trade.
If the stock price falls below the lower strike put option—the purchased put—both put options would have lost money, and maximum loss for the strategy is realized. The maximum loss is equal to the difference between the strike prices and the net credit received.
Investors can earn income from the net credit paid at the onset of the strategy.
The maximum loss on the strategy is capped and known up-front.
The risk of loss, at its maximum, is the difference between the strike prices and the net credit paid.
The strategy has limited profit potential and misses out on future gains if the stock price rises above the upper strike price.
Real World Example of a Bull Put Spread
Let's say an investor is bullish on Apple Inc. (APPL) over the next month. The stock is currently trading at $275 per share. The investor implements a bull put spread by:
- Selling one put option with a strike price of $280 for $8.50 to expire in one month
- Purchasing one put option with a strike price of $270 for $2 to expire in one month
The investor earns a net credit of $6.50 for the two options contracts ($8.50 credit - $2 premium paid). Since one options contract equates to 100 shares of the underlying asset the total credit equals $650.
Scenario 1 Maximum Profit
Let's say the Apple's stock rises and is trading at $300 at expiry. The investor's maximum profit is achieved and equals $650 ($8.50 - $2 = $6.50 x 100 shares = $650). Once the stock rises above the upper strike price, the strategy ceases to earn any additional profit.
Scenario 2 Maximum Loss
If Apple's stock is trading at $200 per share or below the low strike, the investor's maximum loss is realized. However, the loss is capped at $350, or ($280 put - $270 put - ($8.50 - $2)) x 100 shares.
Ideally, the investor is looking for the stock to close above $280 per share on the expiration, which would be the point the maximum profit is achieved.