Options Strategies – Bull Put Spread
Spreads versus naked positions
Most professional options traders prefer initiating a spread strategy versus taking on naked option positions. There is no doubt that spreads tend to shrink the overall profitability (max profits), but at the same time spreads give you a greater visibility on risk (max loss).
Always remember “Professional traders value ‘risk visibility’ more than the profits.”
It’s a much better deal to take on smaller profits as long as you know what would be your maximum loss under worst case scenarios.
Another interesting aspect of spreads is that invariably there is some sort of financing involved, wherein the purchase of an option is funded by the sale of another option. In fact, financing is one of the key aspects that differentiate a spread versus a normal naked directional position.
Why Bull Put Spread?
Now, Similar to the Bull Call Spread, the Bull Put Spread is a two leg option strategy invoked when the view on the market is ‘moderately bullish’. The Bull Put Spread is similar to the Bull Call Spread in terms of the payoff structure but however there are a few differences in terms of strategy execution and strike selection. The bull put spread involves creating a spread by employing ‘Put options’ rather than ‘Call options’ (as is the case in bull call spread).
The payoffs from both Bull call spread and Bull Put spread are similar, here is why should one choose a certain strategy over the other?
Well, this really depends on how attractive the premiums are. While the Bull Call spread is executed for a debit, the bull put spread is executed for a credit. So if you are at a point in the market where –
- The markets have declined considerably (PUT premiums have swelled)
- The volatility is on the higher side
- There is plenty of time to expiry
you have a moderately bullish outlook looking ahead, then it makes sense to invoke a Bull Put Spread for a net credit as opposed to invoking a Bull Call Spread for a net debit.
Normally most traders prefer strategies which offer net credit rather than strategies which offer net debit.
The Scenario’s and Break evens are very easy to calculate.
The best-case scenario is for the market to close at or below low leg, in which case the spread will pay profits. Regardless of where the underlying ends, the maximum reward for the spread if fixed. After deducting the spread cost, the total profit for the deal is Net premium received at higher than first leg – initial spread cost
If the market closes at or higher than breakeven, that is the worst-case scenario. Because the calls are both out-of-the-money and thus worthless. The trader loses the entire spread cost of initially paid.
If the trader had simply bought the call at say 100 rupees, he would have lost Rs 100 but with this spread instead of 100, he will lose only 100 – amount received for selling the call which restricts the max loss
similarly the max profits are limited with the width of the spread between the higher leg and lower leg.