The bull put spread is an extension of the short put strategy. To limit the down- side risk an investor simply buys an additional put at a strike price below the short put strike price. This places a limit on your risk in the trade.Imagine the following scenario:

Welcome to the bull put spread!

The Bull Put Spread is a 'CREDIT SPREAD'.

In very simple terms, a spread is an option strategy, or position, that is composed of both long option contracts and short option contracts, of the same type (call or put), and on the same underlying stock (or index). The sides of a spread, i.e., the long option(s) and the short option(s), are commonly called the “legs” of the position, and for most spreads, each leg would by itself benefit from an opposite move, bullish or bearish, in the underlying stock (or index). As opposed to the outright purchase or sale of calls or puts, spreads are termed “complex” strategies, a term that reflects their composition (of different pieces) rather than any level of difficulty in understanding their use.

Spreads can be broadly categorized: vertical spreads, horizontal spreads and diagonal spreads (or variations thereof). Each of these may further be categorized by type: call (composed of only call contracts) or put (composed of only put contracts). The profit & loss profiles of each spread category will be somewhat different. Let’s take a closer look at these terms:

The spreads most commonly used by investors are vertical spreads and horizontal spreads.

Another category of widely used complex option strategies comprising two legs, but which are not by definition spread, are straddles and strangles. These don’t follow our definition of spreads literally, because they are composed of both calls and puts, either all long contracts or all short ones. However, the two legs of each of these strategies can be characterized as one bullish and one bearish. For educational purposes, or for sake of convenience, we will include these strategies in the larger family of spreads.

In terms of cash flow upon establishing spread, straddle or strangle positions, there are debit spreads and credit spreads:

Generally, a debit spread will be established (or purchased) at a net debit but will be closed (sold or liquidated) at a net credit. The opposite is true for credit spreads; they may initially be established (or sold) for a net credit, but will be closed (bought back or liquidated) at a net debit. Sometimes, however, a spread may be established or closed for “even money,” or with the total cash amount paid out equaling the total cash amount received.

The bull put spread is made up entirely of put options on the same underlying stock (or index). It’s constructed by selling a put option at one strike price and purchasing a put with a lower strike price but the same expiration month. The ratio of long puts to short must be 1:1. The result is a position consisting of a short put (higher strike) and a long put (lower strike). An investor with this position can be said to hold a bull put spread.

Since the long, lower-strike put will cost less than the premium received for the short, higher strike put with the same expiration, a bull put spread will always be established at a net credit.

In other words, the amount of cash received is more than the cash paid out.

Look at the option quote for the QQQ below:

To establish a bull put spread with QQQ options, we might sell 1 QQQ May 27th $105 put for $0.85, and at the same time buy 1 QQQ May 27th $104 put for $0.70. The result is us holding 1 QQQ May 27th $105/$104 bull put spread, at a $0.15 ($0.85 – $0.70) net credit or $15 in total.

This doesn’t sound like much but hold your judgment for a while.

The bull put spread is a moderately bullish position. We are bullish on the QQQ and expect to profit from an increase in its price. However, it’s a moderately bullish position since we generally expect QQQ to increase up to or slightly above the $105 short put’s higher strike price by expiration. Above that level, the profit is capped. A more bullish investor might instead simply buy calls, buy a bull call spread or simply purchase the stock.

Since we are only moderately bullish on QQQ the risk of selling the $105 put on its own might represent more downside risk than we are willing to take. By purchasing the lower-strike $104 put, the downside risk of the $105 short put is covered and in effect reduced by the long put if our bullish forecast is incorrect and the share price of QQQ falls. The trade-off for buying downside protection in this manner is the reduced upside profit potential on the short put contract.

The maximum upside profit for a bull put spread is limited to the net credit initially received when establishing it. This profit will be seen if QQQ closes at or above the $105 higher strike price of the short put at expiration.

Max profit in the QQQ May 27th $105/$104 Bull put spread = $0.15 or $15 per contract.

When we compare the $105/$104 bull put spread to the $105 short put strategy you can see that the profit potential is higher with the short put. See matrix below:

This is an obvious downside to the strategy but you should hold your judgment for now. We will demonstrate later that the risk is a lot lower and when measured on a return on investment basis, the bull put spread can offer better returns.

The maximum downside loss for a bull put spread is limited to the difference between the puts’ strike prices, less the credit initially received for the spread. This loss will be seen if QQQ closes at or below the lower $104 strike price of the long put at expiration, no matter how low QQQ declines.

The maximum loss for the QQQ May 27th $105/$104 Bull Put Spread: $1 (difference between $105/$104) - $0.15 (Credit Received) = $0.85 or $85 per contract.

If the price of QQQ falls below $104 at expiry we will make our maximum loss. This is the real benefit of this strategy versus the short put strategy. If we placed the $105 short put on the QQQ instead and we are incorrect in our forecast, our losses continue to mount as the share price falls. On the flip side with the bull put spread, losses are capped.

See matrix below:

When you looked at the premium received for this trade, you might have balked at the mere $15 per contract that you were receiving. But take into consideration that you are only risking $85 to make the $15.

Return on investment is calculated as follows:

(profit potential divided cost of the trade) multiplied by 100

In our QQQ example,

$15 (profit) / $85(cost)*100

ROI = 17.65%

Looking at the figures now from a return on investment perspective, 17.65% in 1 month is very impressive. When we discuss probability later you will see just how impressive this return is.

The break-even price for a bull put spread at expiration is a closing QQQ price equal to the $105 higher strike price of the short put minus the $0.15 credit received for the spread.

The break-even price for the QQQ May 27th $105/$104 Bull Put Spread = $105 (higher strike) minus $0.15 (credit received) = $104.85.

In other words, the share price can fall to $104.85 at expiration and we still make a profit. When we compare, the bull put spread to the short put, you can see that the short put offers a lower and better break-even price. See below:

When you buy a stock the only way you can profit is when the share price rises or when you get paid a dividend. Another major advantage of the bull put spread strategy is the downside leeway it gives you. The share price of QQQ could fall by a certain amount and we would still make a profit.

Remember in our QQQ example. The share price of QQQ was $108.45 when we placed the $105/$104 bull put spread. The breakeven on the strategy is $104.85. This means that the share price of QQQ could fall $3.60 ($108.45-$104.85) before we make a loss at expiration. This is the equivalent of a 3.32% fall in the value of the QQQ share price. We call this the ‘downside leeway’.

Now let’s consider our chances of making a profit. Which is more likely, QQQ to close above $104.85 or QQQ to close above $108.45? Obviously, QQQ has a much better chance of closing above $104.85. Most online brokers will tell you the probability of profit on every option trade you place. The probability with the QQQ $105/$104 bull put spread example was 78%.

Does this mean we are guaranteed to make profit? No, but it means that we have much better odds.

In fact, when you buy a share you only have a 50/50 chance of profit. That’s why using the bull put spread strategy is more likely to produce a profit than buying the shares. When we compare the bull put spread to the short put the downside leeway is slightly lower and therefore the probability of profit of profit will be lower also.

When you are deciding which strategy is right for you, you must weigh up the probability of profit versus the risk versus the reward. Every investor is different, so there is no right or wrong answer. But take this as a word of caution, most of us by our very nature, will look at the higher reward scenario. Unfortunately, we do not consider the risks enough. A great exercise to help here is to create the profit and loss tables for each strategy and then ask yourself, if the share price fell to X or Y, could I handle the loss?

At expiration, if QQQ closes between the break-even price and either of the two strike prices, either a partial loss or partial profit would be seen. Above the break- even price there would be a partial profit; below the break-even price there would be a partial loss.

Before expiration, an investor can take a profit or cut a loss by purchasing the spread in the marketplace. This involves selling the long put and buying the short put, which will be done at a net debit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the credit initially received for the spread and the debit paid to close it.

It is important for you to get into the habit of creating profit and loss tables. Here is an example of a P&L table for the QQQ May 27th $105/$104 Bull Put Spread. Remember the spread:

As you can see from the above P&L table you are risking $85 to make $15 for an ROI of

17.65% with a 78% probability of profit. Not bad, I think you will agree?

The financial impact of a change in volatility depends on whether one or both of the puts are in-the-money and the amount of time until expiration. It is best to place the bull put spread when implied volatility is high.

For a bull put spread, if the underlying stock (or index) is closer to the lower strike of the long put, losses should increase at a faster rate as time passes. Conversely, if the underlying stock (or index) is closer to the higher strike of the short put, profits should increase at a faster rate with time. Look at the put option quotes on QQQ again:

We have two positions to consider for our bull put spread:

First, we are short on the $105 put. The theta value is -0.0289. But remember we sold the $105 put so the theta sign changes to +0.0289.

Second, we bought the QQQ $104 Put. The theta value of the $104 put is -0.0268.

This gives us a net theta for QQQ May 27th $105/$104 Bull Put spread of +0.0021 (0.0289-0.0268).

This means that the time value of the $105/$104 bull put spread will erode by $0.0021 per share or $0.21 total per day. Now theta is working to our advantage as the value of the bull put spread continues to decay as time passes.

Delta is the rate of change in the value of an option for a $1 move in the underlying share price. Look at the QQQ put option quotes below:

In our example with the QQQ May 27th $105/$104 Bull Put Spread, we have two positions to think about.

First, we are short the $105 put with a delta of -0.2451. But remember we sold this put so the delta changes to +0.2451. Second, we bought the $104 put with a delta -0.1988. This gives us a net delta position of +0.0463 (0.2451-0.1988).

This means that the value of the QQQ May 27th $105/$104 Bull Put spread will go up by $0.0463 per share or $4.63 total for every $1 rise in QQQ and vice versa.

We can also consider delta as being long or owning 4.63 shares of QQQ. Think about it...if QQQ rose by $1 and we owned 4.63 shares we would make a profit of $4.63.

A couple of things to know about delta:

Some bull put spreads can be considered more bullish than others. The degree of bullishness depends primarily on the strike price of the short put, which determines how high the underlying stock (or index) needs to increase for maximum profit to be realized at expiration.

Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money.

For an equity put option, early assignment generally occurs when the short put is deep in-the money, expiration is relatively near, and its premium has little or no time value. If a bull put spread holder is assigned early on the short put, then he might exercise his long put, if it is in the- money, and sell shares purchased via the assignment obligation. In this case, maximum loss on the bull put spread would be realized.

Note: An investor with a bull put spread is short a higher-strike put and long a lower-strike put. It is therefore entirely possible that if the short-put is in-the-money and early assignment is received, the long put would be out-of-the-money. In this case, it may not make financial sense to exercise the long put early to sell shares purchased via the assignment obligation. So, the investor has choices:

An investor contemplating the use of a bull put spread should consider the consequences of early assignment, and in advance discuss with his broker a course of action to take if assigned.

If early assignment is received on a short in-the-money put of a bull put spread, the cash settlement procedure for index options will create a debit in the investor’s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner.

After receiving assignment notification, usually the next business day, if his long put is also in the-money the investor may exercise that contract. The cash settlement amount credited to his account will be determined at the end of that day. There is a full day’s market risk if the long option is not sold during the trading day assignment is received. If the long put is not in-the money, after the cash settlement amount is debited from his account via assignment the investor would remain long an out-of-the-money index put.

The action you take at expiry will depend on where the share price is trading at:

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