Understanding the Bullish Put Spread Strategy

Bull Put Spread Strategy: Options trading has a variety of strategies that allow traders to explore different market conditions. Among these strategies, the bullish put spread stands out as a versatile tool for those looking to profit from moderately bullish sentiment.

In this article, we will use real-world examples to understand what the bull market spread strategy consists of, how it works, and its pros and cons.

What is Bull Put Spread Strategy?

The bullish put spread is a two-legged options strategy used when the view on the underlying security is mildly bullish or neutral. It is also called a put-sell strategy with limited losses.

In this strategy, you sell one at the money (ATM) put option and buy one out of the money (OTM) put option on the underlying security with the same expiration date.

This strategy is deployed when you expect the underlying security to have a small or large upward move, a very small downward move, or when you expect the market to trade near the ATM strike price.

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To develop a bull market spread strategy, you need to construct the legs of options you need.

The legs are as follows:

• First leg:- Sell one in cash (ATM) put option exercise.
• Second leg:- Buy one of the out-of-the-money (OTM) put option strikes.

Here, you can also consider the ITM (in the Money) strike option instead of the ATM (at the Money) strike option. While selling a put option, one buys an OTM put option to prevent sudden price fluctuations.

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Let us take an example to clearly understand the above configuration.

Assume Nifty 50 is trading at spot price 19665. The option legs for the assumed spot price are shown below.

• Sell ​​1 lot of 19650 strike price put option at a premium of Rs 85.
• Buy 1 lot of 19450 strike put option at a premium of Rs 35.

In the above example, the net premium received is Rs 50.

That is, (85–35) = 50.

The margin required to deploy this strategy is less compared to the basic putsell strategy.

On the other hand, to get the margin benefit, you need to execute the buy leg first and then the sell leg. Otherwise, the capital required for this strategy will increase.

For the above example strike price and premium, the margin requirement is between Rs 25000 and Rs30000.

maximum profit and maximum loss

• The maximum benefit of this strategy is limited. Calculated as net premium received. That is, 50 (net premium) x 50 (lot size) = Rs 2500.
• The maximum loss is calculated by subtracting the strike price difference from the net premium at expiration.

That is, strike price difference = 19650–19450= 200.

Maximum loss = 200–50 (net premium)= 150 x 50 (lot size) = Rs 7500.

Break-even point

This strategy consists of a single break-even point.

• Breakeven Point = Sell Strike Price – Net Premium Received.

In the above example, it is calculated as (19650 – 50 = 19600).

payoff chart

From the payoff chart you can understand:

• This strategy earns maximum profit if the underlying security expires above the short option put strike price.
• Additionally, the strategy incurs maximum losses if the underlying security expires below the long option put strike price.
• The break-even point on the payoff chart indicates that you will make a profit if the underlying security expires above the break-even point, and you will make a loss if it expires below the break-even point.

Advantages

• Even if your prediction is slightly wrong, i.e. the stock price falls slightly, you can still make money.
• If the prediction is wrong, buying a low Put protects against large losses and acts as a stop loss.
• Theta decay favors this strategy.
• The margin required is much less compared to the basic options selling strategy.
• This strategy offers the freedom of scalability as maximum risk and reward can be determined in advance. Best suited for risk-averse traders.

disadvantage

This strategy has the disadvantage of incurring losses when implied volatility (IV) increases. As the IV goes up, the option premium will also go up, but like this strategy, you can make a profit only when the option price falls sharply.

Finishing

After understanding the bull market spread strategy, you will conclude that this strategy has a lot of scope and application when you have a slightly bullish to neutral view of the market.

A better understanding of options strategies allows you to improvise setups for good risk-reward ratios through better risk management.

Written by Deepak M

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