The bull put spread strategy is one of the most popular ways to trade when expecting a moderate increase in an asset’s price. By buying a put option at a lower strike price and selling another put option at a higher strike price with the same expiration, you create a bull credit spread that offers limited risk and reward. Read on to learn more about the practical considerations you need to keep in mind before using the bull put spread strategy.
Key takeaways
- The bull put spread strategy is a trade setup typically employed when an investor anticipates a moderate increase in the underlying asset’s price.
- To build a bull put spread, you need to buy a put option at a lower strike price while selling another put option at a higher strike price with the same expiration date.
- The strategy represents a credit spread, meaning the investor receives a net credit upon entering the trade, and time works in your favor.
What Is the Bull Put Spread Strategy?
As a bull credit spread, the bull put spread strategy is an income-generating options strategy used when you expect a moderate rise in the price of the underlying asset.
The bull put spread strategy involves two put options:
- Sell: A put option at a higher strike price.
- Buy: Another put option at a lower strike price, both with the same expiration date.
In general, you will find the profit and loss (P&L) profile of this bull put spread strategy to look like this:
This is just what you will see on our options screener. Note the capped loss and profit, we will tell you more on the matter later in the article. For now, just consider this: the setup described above creates a range and generates a net credit from the difference in premiums.
A Credit Strategy
The primary aim of the bull put spread is to generate income through net premium received:
- Selling the Higher Strike Put: This generates income.
- Buying the Lower Strike Put: This offsets assignment risk and protects against a sharp downward move in the stock price.
- Net Credit: The difference between the premiums of the two options results in a net credit, representing the maximum profit if the underlying asset’s price stays above the higher strike price at expiration.
How Does the Bull Put Spread Strategy Work in Practice?
Consider an investor who believes a stock will trade above $280 per share over the next month. Let’s say the stock currently trades at $275 per share. To implement a bull put spread:
- Sell: One put option with a $280 strike price for $8.50, expiring in one month.
- Buy: One put option with a $270 strike price for $2, expiring in one month.
The investor receives a net credit of $6.50 per share, or $650 for 100 shares. If the stock rises to $300 at expiry, the maximum profit of $650 is achieved. If the stock falls to $270 or below, the maximum loss is capped at $350. Note that, as you can see from the previous P&L chart, there will be a linear change in the profit (or loss) of the strategy between the two mentioned price levels.
Comparison with Other Bullish Strategies
- Bull Call Spread: Involves buying a call option at a lower strike price and selling another call option at a higher strike price. Both strategies aim to profit from a moderate rise in the underlying asset’s price, but the bull call spread strategy requires an initial debit, whereas the bull put spread provides an initial credit. In terms of timing, consider that you will opt for a bull put spread or a bull call spread based on parameters such as the options’ liquidity and the strategy’s profit ratio.
- Long Call: Provides unlimited profit potential if the underlying asset’s price rises. However, unlike the bull put spread, it also involves a maximum loss equal to the premium paid for the option. You may want to go for a long call strategy whenever there is high volatility, as you may see the call you bought as a relatively cheap way to earn higher than 100% profits in a bullish scenario, against a capped loss risk.
- Short Put: Involves selling a put option at a strike price with a bullish bias. The strategy resembles one leg of a bull put spread. Unlike the bull put spread, there is no protection against significant downward moves in the stock price. A short put may work very well when you plan to manage your position, for instance by rolling it, closing it early, and so on.
Bull Put Spread Example – A Real-Life Trade
An example, as always, will help clarify the bull put spread strategy. Let’s consider Caterpillar (CAT), currently trading at $331.52. Suppose you believe there are reasons to be more bullish than bearish on this stock, such as a recent good earnings report or a generally positive sentiment toward industrial companies.
Setting Up the Trade for our Bull Put Spread Example
In this case, you might spot the following bull put spread trade opportunity on our options screener:
- Buy: A $312.5 put option.
- Sell: A $327.5 put option.
- Expiration: Both options expire in one week.
With this trade setup, this is the P&L profile you would have:
What does the chart below tell you? First of all, focus on the capped loss and profit:
- Maximum Loss: above $1,000.
- Maximum Profit: almost $500.
Here’s how it works:
- Net Credit: The difference between the premiums of the sold and bought puts results in a net credit received upfront.
- Breakeven Point: $322.82 (the strike price of the sold put minus the net credit received).
If CAT remains above $322.82 until expiration, both put options will expire worthless, and you keep the net premium received. This means you achieve the maximum profit.
However, if the stock falls below this breakeven point, your losses will start to accumulate. The maximum loss occurs if CAT drops below $312.5 by expiration. In that scenario, the long put fully offsets the short put, capping your loss.
What could happen? Let’s break this down:
- Scenario 1: CAT stays above $327.50 – Both puts expire worthless. You keep the entire net premium received.
- Scenario 2: CAT stays above $322.82 but below $327.50 – The $327.50 put is in the money; you may need to buy back the put at expiration. Your profit is reduced but remains positive.
- Scenario 3: CAT falls below $322.82 – Your losses start to increase. The $327.50 put is deep in the money. The maximum loss is reached if CAT falls below $312.50.
Consider Closing Earlier than Expiration (and Keep Your Eyes on the Historical Price Chart)
It’s important to note that you can close this trade earlier if you feel your position becomes too risky. The profit ratio in this case is close to 50%, which may not look bad if you consider this to be a high-probability trade. Monitoring the market and being ready to act if conditions change can help manage risk effectively.
Taking a look at CAT’s historical price is also a smart choice:
Specifically, you will see that the $322.82 breakeven price is close to a recent price support level. This is good for you because if the stock price starts to decline, there’s a good chance that the bulls will defend this support level, preventing further losses. This historical context provides an additional layer of confidence in your trade setup.
Things to Remember
- Bull Put Spread Strategy: Involves buying a lower strike put and selling a higher strike put, both with the same expiration date.
- Income Generation: Generates income through the net premium received from the bull credit spread. Also, consider that time plays in your favor (i.e., time decay will increase your likelihood of profit).
- Risk and Reward: Offers limited profit potential but also caps the maximum loss, making it a controlled-risk strategy.
- Effective Conditions: Best used when you expect the underlying asset to rise moderately or remain stable, providing a profitable yet cautious approach.
Therefore, the bull put spread strategy can be a useful tool for generating income with limited risk, especially when you have a moderately bullish outlook on a stock like CAT. You could pick a good stock (i.e., a stock of a company with good growth prospects and solid financials) and set regular bull put spreads on a monthly basis. This does not mean you will always be right, but that’s certainly something worth considering.
Pros and Cons of the Bull Put Spread Strategy
Pretty much like any options strategy, the bull put spread strategy has its own set of advantages and disadvantages. Here’s a straightforward table summarizing the pros and cons of the bull put spread strategy:
Pros of the Bullish Put Spread
- Limited Risk and Reward: Both the potential profit and loss are capped. The maximum gain is the net premium received at the outset, making it easier to manage risk.
- Generates Income Through Net Premium: By selling a higher strike put and buying a lower strike put, you receive a net premium upfront. This net credit can be beneficial, especially in a stable or moderately bullish market.
- Profits if the Stock Price Holds Steady or Rises: The strategy profits if the underlying stock price remains above the higher strike price until expiration. This makes it a good choice for investors expecting a moderate rise or stability in the stock price.
Cons of the Bullish Put Spread
- Potential for Lower Profit or Loss if the Stock Declines: If the stock price falls below the higher strike price, the sold put option may be exercised, leading to potential losses. The maximum loss occurs if the stock price falls below the lower strike price.
- Requires Careful Selection of Strike Prices to Balance Risk and Reward: Choosing the right strike prices is crucial. The balance between the premiums received and the risk of the stock price falling below the lower strike price needs careful consideration.
- Assignment and Expiration Risks: There is always a risk that the sold put option could be assigned if the stock price falls below the strike price before expiration. This could lead to unexpected obligations to buy the stock, but you will still have the other option in your portfolio, meaning that your loss can never go above the initial max cap.
Manage Your Risk
Managing risk is crucial when using the bull put spread strategy. Understanding the potential risks and how to mitigate them can help you navigate this options strategy more effectively.
Assignment Risk
- Early Assignment: Early assignment of the short put option can occur anytime but is more likely when the put goes deep into the money. If this happens, your long put can cover the short put assignment, but you’ll need to finance a long stock position for one business day.
- Special Situations: Events like mergers, takeovers, spin-offs, or special dividends can disrupt typical expectations regarding early exercise of options. Be prepared for unexpected outcomes in such scenarios.
Expiration Risk
Holding the bull put spread until expiration adds risk because you won’t know if you’ll be assigned on the short put until the Monday after expiration. This uncertainty is particularly risky if the stock is trading near the short put strike price. There are two scenarios to consider:
- Scenario 1: The short put ends up slightly in-the-money. You might sell the stock short in anticipation of being assigned. If assignment doesn’t happen, you could end up with an unintended net short stock position, exposing you to potential losses if the stock rises over the weekend.
- Scenario 2: You bet against being assigned, but it happens. You end up with a net long position in a stock that may have lost value over the weekend.
To mitigate these risks, consider closing the spread early or be prepared for either outcome on Monday. Monitoring the stock closely, especially on the last trading day, is essential.
What Should You Remember About Managing a Bull Put Spread Strategy?
- Limited Risk and Reward: The bull put spread strategy offers limited risk and reward. The maximum loss is the difference between the strike prices minus the net credit received, while the maximum profit is the net credit received.
- Income Generation: This bull put spread strategy generates income through the net premium received upfront, making it suitable for moderately bullish market conditions.
- Strike Price Selection for the Bullish Put Spread: Careful selection of strike prices is crucial to balance risk and reward. The goal is to choose strike prices that maximize the net credit while minimizing the risk of the stock falling below the lower strike price.
Monitoring and Adjustment: Regularly monitor the stock and be prepared to adjust your position if necessary. Closing the spread early can help avoid the uncertainties associated with expiration.
