Bull Put Spread Strategy: In options trading, there are various strategies that allow traders to navigate different market conditions. Among these strategies, the bull put spread stands out as a versatile tool for those seeking to benefit from moderately bullish sentiment.
In this article, we shall understand bull put spread strategy with its components, working, pros and cons with a real example.
Table of Contents
What is Bull Put Spread Strategy?
A bull put spread is a two-legged options strategy that is used when the view is mildly bullish to neutral on the underlying security. It is also referred to as a put-sell strategy with limited loss.
In this strategy, one ATM(at the money) put option is sold and one OTM(out of the money) put option is bought on the underlying security with the same expiration date.
This strategy is deployed when you expect underlying security to have a small or big up move, a very small down move and or you expect the market to trade near the ATM strike price.
Construction
To deploy the bull put spread strategy, we need to construct legs of the required options.
The legs are:-
- First leg:- Sell one at the money(ATM) Put option strike.
- Second leg:- Buy one out of the money(OTM) Put option strike.
Here, instead of an ATM(at the money) strike option, an ITM(in the money) strike option can also be considered. As we sell a put option, to protect against dramatic movement in the prices, we buy one OTM Put Option.
Example
Let us understand the above construction clearly with an example.
Assume Nifty 50 is trading with a spot price of 19665. The option legs for the assumed spot price are as considered below.
- Sell one lot of 19650 strike put option, in which the premium of Rs 85 is received.
- Buy one lot of 19450 strike put option, in which the premium of Rs 35 is paid.
In the above example, the net premium accounts for Rs 50 received.
I.e (85–35) = 50.
The margin required to deploy this strategy is less compared to the naked put-sell strategy.
Whereas, to get the margin benefit you should execute the buy leg first and next the sell leg, or else the capital required will increase for this strategy.
For the above example strike prices and premiums the margin requirement will be between Rs 25000 to Rs30000.
Maximum profit and Maximum loss
- The maximum profit in this strategy is limited. It is calculated as the net premium received. I.e 50(net premium) x 50(Lot size) = Rs 2500.
- At the expiry, the maximum loss is calculated when the difference in the strike price is subtracted from the net premium.
I.e strike difference = 19650–19450= 200.
Max Loss = 200–50(net premium)= 150 x 50(lot size) = Rs 7500.
Breakeven Points
The strategy consists of a single breakeven point:-
- Break-even point = sell strike price – net premium received.
For the above example, it is calculated as (19650 – 50 = 19600).
Payoff chart
From the payoff chart, it can be understood that:-
- The strategy makes a maximum profit if the underlying security expires above the Sell option put strike price.
- Also, the strategy makes a max loss if the underlying security expires below the buy option put strike price.
- The breakeven point in the payoff chart tells that if an underlying security expires above the breakeven point it will be a profit and if it expires below the breakeven point it will be a loss.
Pros
- You will make money even if your prediction is slightly wrong, i.e., when the stock moves down a bit also.
- In case, the prediction is wrong, the lower Put bought prevents big losses and acts like a stop loss.
- Theta decay is in favour of the strategy.
- The margin required is much less compared to the naked option selling strategy.
- This strategy gives the Liberty of scalability as the maximum risk and reward can be ascertained beforehand. It is best suited for Risk-averse Traders.
Cons
This strategy has minimal cons, when the implied volatility(IV) goes up the strategy will incur loss. As IV goes up, option premiums will also go up but as in this strategy, the option prices should fall drastically to make profits.
In Closing
Having understood the bull put spread strategy, we shall conclude that the strategy has a lot of scope and application when there is a mildly bullish to neutral view on the market.
With a better understanding of the option strategies, one can improvise the setups for good risk-reward ratios with better risk management.
Written By Deepak M
By utilising the stock screener, stock heatmap, portfolio backtesting, and stock compare tool on the Trade Brains portal, investors gain access to comprehensive tools that enable them to identify the best stocks, also get updated with stock market news, and make well-informed investment.
