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Understanding Credit Spreads for Bullish Moves
For investors who are bullish on a particular stock or sector over the near term but want to limit their potential losses, the bull put spread options strategy can be an appealing alternative. This strategy involves buying put options at a lower strike price while selling put options at a higher strike price on the same underlying stock or sector. The position is opened with a net credit.
What is a bull put spread?
A bull put spread is a trading strategy that involves two actions:
Sell a put option
The position’s profit comes from the premium collected from the sale of this option. The short put’s value can drop with a rise in the underlying price or a decline in volatility. The trade profits when the put expires out-of-the-money or is bought to close the position at a lower price than its initial sale. While selling a strike closer to the underlying price will offer a higher premium, it also increases the risk of the option finishing in the money and early assignment.
Buy a Lower Strike Put Option
Bull put spread risk/reward profile:
- Reward: The net premium collected.
- Breakeven: Higher strike minus the premium received.
- Risk: The difference between the two strikes minus the premium collected and early assignment on the short leg.
| Quick Reference Guide: Bull Put Spread | |
|---|---|
| Market outlook | Bullish |
| Position net debit or credit | Credit (premium collected) |
| Margin required | The difference between the strikes, minus the premium collected |
| Number of legs | Two – one lower strike long put and one higher strike short put |
| Maximum profit | The premium collected |
| Profits from | The options expiring with the underlying above the short strike put, or from the underlying price rising, or from volatility dropping |
| Maximum loss | The difference between the strikes minus the premium collected. This occurs if the underlying price drops below the long put strike. |
| Breakeven | Short strike minus the premium received |
| Risk from | The underlying price drops at or below the strike of the long put or assignment on the short put before expiration |
| Options level required | Level 3 – Click here for additional information |
Strategy comparison
Let’s use an example to compare the bull put spread to other bullish strategies, like buying a call or the stock. Apple Inc., with the symbol AAPL, appears to be moving upward from support at about $170 to resistance at approximately $180.
Our first trader, BPS, is using the bull put spread to attempt to profit from the upward price movement. Our next trader, LC, is buying a call option to trade the move. Finally, ST is a trader who buys stock they think will increase in price.
BPS is selling the 165/170 bull put spread with 30 days until expiration for 1.23.
LC is buying a 170 call for 9.55. They chose an option with a farther expiration. This is because they are trying to time the exit so the underlying target price is reached while the option still has more than 30 days until expiration. This reduces the effect of time decay on the position.
ST is buying 100 shares of Apple stock for $173.70 per share.
| Bull Put Spread | Long Call | Long Stock | |
|---|---|---|---|
| Trade cost /margin | $377 (Difference between strikes minus premium X 100) |
$955 Premium X 100 shares |
$17,370 $173.70 X 100 shares |
| Maximum loss | $382 | $955 | $17,370 |
| Breakeven price | $168.77 | $179.55 | N/A |
| Maximum profit | $123 | Unlimited | Unlimited |
| Realistic profit at target | $123 – options expired out-of- the-money | $276.30 – sold on April 12th, underlying at $180 | $630 – sold on expiration day of options at $180 |
| Rate of return at the target | 32.6% | 29% | 3.6% |
| Drawbacks/Risks | 1. Options expiring with the underlying below the short strike 2. Assignment risk on the short put 3. More commissions |
1. Higher cost 2. Option expires with the underlying below breakeven 3. Underlying price doesn’t move fast/ far enough |
1. Highest cost 2. Lowest rate of return 3. The stock price drops below purchase price |
| Features | 1. Lower cost 2. Lower max risk 3. Higher rate of return 4. Can profit with little or no price movement |
1. Unlimited potential profit 2. Simple strategy, one leg 3. One commission 4. No assignment risk |
1. No time limit/ decay 2. Can receive dividends 3. Simple strategy 4. One commission |
Conditions for a bull put spread
The bull put spread tends to be used when the trader holds a neutral to moderately bullish outlook on a stock or index over the short-term time frame of the options. The trader expects the puts to expire worthless so they can potentially capture the entire net credit received when initiating the spread as profit. The bull put spread may have a lower cost and may potentially offer lower risk than buying call options outright.
Traders may opt for a bull put spread when implied volatility is relatively high, as this could make the options more favorably priced, resulting in a larger credit upon entry. The spread benefits from decreasing volatility and time decay, both of which may lower the spread price if the trader needs to buy to close it before expiration.
Strike selection
If the short strike is closer to the underlying price, more credit will be received at entry, but risk of assignment or the option finishing in the money greatly increases. The short strike should be at or near a support level. This may increase the probability of the option expiring out of the money.
The long put’s strike should be far enough below the short strike to receive a sufficient premium when the spread is opened. The difference between the strikes determines the maximum risk, which must be considered when choosing the long strike.
How to place a bull put spread trade
Select a Stock or Index
Choose Strike Prices and Expiration
Considerations
- The strike of the bought put determines the position’s risk because the difference between strikes minus the premium collected is the potential loss. The premium paid for the long put will reduce the premium collected from the short put. The maximum loss is the difference between the strikes minus the premium collected.
- The strike of the sold put should be as high as possible to collect a premium but below where the price of the stock or index is expected to be when the options expire. The maximum profit is the net premium collected at entry.
- Because this is a credit spread, time decay helps the position. The options in the spread can be allowed to expire if they are out of the money. To experience more significant time decay, expirations that are less than thirty days out could be chosen. Time decay increases exponentially within the last thirty days before options expiration.
- Choosing longer expirations may offer greater premiums, but they experience slower time decay and may increase the possibility of assignment on the short put. Selecting deeper out-of-the-money options may lower the chance of assignment and the premium received.
Exiting the bull call spread
Test before you trade
Access the TradeStation platform in Simulated Trading mode to acquaint yourself with strategy analysis and order entry. Utilize this environment to practice placing bull put spreads without exposing real money, allowing you to gain confidence in executing the strategy.
Conclusion
The bull put spread is a helpful strategy for investors seeking to profit from expected stock rises while managing risk. This involves selling a put option and buying a lower strike put. The strategy looks to profit from collecting premiums and benefits from time decay, decreased volatility, and upward price movement in the underlying. It offers limited reward and potential increased loss and requires thoughtful strike selection and diligent trade monitoring. Traders typically want the options to expire out-of-the-money to maximize potential profits. Explore and learn the intricacies of the bull put spread, as it could potentially be used as a versatile tool for navigating bullish market conditions and managing financial objectives.
This content is for educational and informational purposes only. Any symbols, financial instruments, or trading strategies discussed are for demonstration purposes only and are not research or recommendations. TradeStation companies do not provide legal, tax, or investment advice.
Options trading is not suitable for all investors. Your TradeStation Securities’ account application to trade options will be considered and approved or disapproved based on all relevant factors, including your trading experience. See www.TradeStation.com/DisclosureOptions. Visit www.TradeStation.com/Pricing for full details on the costs and fees associated with options.
Any examples or illustrations provided are hypothetical in nature and do not reflect results actually achieved and do not account for fees, expenses, or other important considerations. These types of examples are provided to illustrate mathematical principles and not meant to predict or project the performance of a specific investment or investment strategy. Accordingly, this information should not be relied upon when making an investment decision.
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