Bull Put Spread

A Bull Put Spread involves being short a Put option and long another Put option for same expiration but with a lower strike. The short Put generates income, whereas the long Put’s main purpose is to offset assignment risk. Because of the relationship between the two strike prices, the investor will always be paid a premium (credit) when initiating this position.

Market Outlook

Moderately bullish to bullish sentiment among market participants.

When to Use

An investor often employs the bull put spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor’s opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase. An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion.

Profit & Loss Chart

Benefit

The bull put spread can be considered a doubly hedged strategy. The price paid for the put with the lower strike price is partially offset by the premium received from writing the put with a higher strike price. Thus, the investor’s investment in the long put, and the risk of losing the entire premium paid for it, is reduced or hedged.

On the other hand, the long put with the lower strike price caps or hedges the financial risk of the written put with the higher strike price. If the investor is assigned an exercise notice on the written put and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased put with the lower strike price. As a trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy.

Risk & Reward

Maximum Profit: Limited
Maximum Loss: Limited

The maximum gain is limited. The best that can happen is for the stock to be above the higher strike price at expiration.  In that case both Put options expire worthless, and the investor pockets the credit received when putting on the position.

The maximum loss is limited. The worst that can happen is for the stock price to be below the lower strike at expiration.  In that case, the investor will be assigned on the short Put, now deep-in-the-money, and will exercise the long Put. The simultaneous exercise and assignment will mean buying the stock at the higher strike and selling it at the lower strike.  The maximum loss is the difference between the strikes, less the credit received when putting on the position.

Break Even Point

Short Put Strike – Net Credit Received

Volatility Changes

Increase In Volatility: Effects Vary
Decrease In Volatility: Effects Vary

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options’ premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay (Theta)

Effect Varies

The passage of time helps the position, though not quite as much as it does a plain short Put position. Since the strategy involves being short one Put and long another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.

Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be a positive. This strategy generates net up-front premium income, which represents the most the investor can make on the strategy. If there are to be any claims against it, they must be occur by expiration. As expiration nears, so does the date after which the investor is free of those obligations.