3.1 – Why Bull Put Spread?
Basics of stock market
• Introduction
• Bull call spread
• Bull put spread
• Call ration Back Spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread
• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor
3.1 – Introduction - Why Bull Put Spread?
First of all The Bull Put Spread, which has two legs like the Bull Call Spread, is used when the market outlook is “moderately bullish.” In terms of payoff structure, the Bull Put Spread is comparable to the Bull Call Spread, but there are some differences in terms of strategy execution and strike choice. The bull put spread involves using put options rather than call options to create a spread (as is the case in bull call spread).
At this point, you might be asking yourself why one should choose one strategy over another when the payoffs from both a bull call spread and a bull put spread are comparable.
Well, this really depends on how attractive the premiums are. While the Bull Call spread is executed for debit, the bull put spread is executed for credit. So if you are at a point in the market where –
- The markets have declined considerably (therefore PUT premiums have swelled)
- The volatility is on the higher side
- There is plenty of time to expiry
In fact, If 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. Apart from this, Personally, I do prefer strategies that offer net credit rather than strategies that offer net debit.
3.2 – Strategy Notes
Firstly, The bull put spread is a two-leg spread strategy traditionally involving ITM and OTM Put options. However, you can create the spread using other strikes as well.
To implement the bull put spread –
Buy 1 OTM Put option (leg 1)
Sell 1 ITM Put option (leg 2)
When you do this ensure –
All strikes belong to the same underlying
Belong to the same expiry series
Each leg involves the same number of options
For example –
Date – 7th December 2015
Outlook – Moderately bullish (expect the market to go higher)
Nifty Spot – 7805
Bull Put Spread, trade set up –
Purchase 7700 PE by paying a premium of Rs. 72; keep in mind that this is an OTM option. This is a debit transaction because money is being taken out of my account.
Selling 7900 PE will earn you Rs 163/- in premium; keep in mind that this is an ITM option. This is a credit transaction because I receive money.
Clearly, The difference between the debit and credit, or the net cash flow, is 163 minus 72, or +91. Since this is a positive cash flow, my account has a net credit.
Undoubtedly, A bull put spread is also known as a “Credit spread” because, generally speaking, there is always a “net credit” in them.
Generally, The market may move in any direction and expire at any level after we place the trade. In order to understand what would happen to the bull put spread at various levels of expiry, let’s consider a few scenarios.
Situation 1: The market closes at 7600 (below the lower strike price i.e OTM option)
The intrinsic value of the Put option determines its value at expiration. If you remember from the previous module, a put option’s intrinsic value at expiration is –
The strike-spot Max
The intrinsic value of 7700 PE would be –
Max [7700 – 7600 – 0]
= Max [100, 0]
= 100
By investing a premium of Rs. 72 and becoming long on the 7700 PE, we would make
= Value at Risk – Premium Paid
= 100 – 72
= 28
Similar to the 7900 PE option, which has an intrinsic value of 300 but was sold or written at Rs. 163,
Refund for the 7900 PE In this case,
163 – 300
= – 137
broader strategy
The overall strategy’s results would be:
+ 28 – 137
= – 109
The market expires in scenario 2 at 7,700 (at the lower strike price i.e the OTM option)
Since the 7700 PE won’t have any intrinsic value, we will forfeit the entire premium we paid, or Rs. 72.
The intrinsic value of the 7900 PE will be Rs. 200.
The strategy’s net payoff would be:
Premium from the sale of 7900 PE less the intrinsic value of 7900 PE less the premium for 7700 PE
= 163 – 200 – 72
= – 109
Situation 3: The market closes at 7900 (at the higher strike price, i.e ITM option)
Since both 7700 PE and 7900 PE have zero intrinsic value, both potions would be worthless when they expired.
The strategy’s net payoff would be:
Received premium for 7900 PE
= 163 – 72
= + 91
Situation 4: The market closes at 8000 (above the higher strike price, i.e the ITM option)
In short, The total strategy payoff would be 7700 PE and 7900 PE since both options would expire worthlessly.
The premium for 7900 PE received minus the Premium for 7700 PE paid
= 163 – 72
= + 91
To sum it up:
Importantly, Three things should be obvious to you after reading this analysis:
When the market moves higher, the strategy is profitable.
Otherwise, No matter how much the market declines, the maximum loss is only Rs. 109, which also happens to be the difference between the strategy’s “Spread and net credit.”
There is a 91 percent profit cap. This also happens to be the strategy’s net credit.
The “Spread” can be described as”
3.3 – Other Strike combinations
By the way, Keep in mind that the spread is the difference between the two strike prices. However, the strikes that you select can be any OTM and any ITM strike. The Bull Put Spread is always created with 1 OTM Put and 1 ITM Put option. The spread increases with strike distance, and the potential reward increases with spread size as well.
Consider the following examples while the spot is at 7612:
Lastly, The key takeaway from this is that you can combine any number of OTM and ITM options to create a spread. However, the risk-reward ratio varies depending on the strikes you select (and consequently, the spread you create). In general, go ahead and create a larger spread if you have a strong conviction in your “moderately bullish” view; otherwise, stick to a smaller spread.
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