Bull (Short) Put Spread
A bull put spread functions in the same manner as a bull call spread, except that put options are used rather than calls options to initiate the trade. In a bull put spread, a “LOWER” put strike is purchased and a “HIGHER” put strike is sold, simultaneously.
The risk profile of a bull put spread is the same as that of a bull call spread because the idea behind the trade is the same – it’s a bullish trade. However, the fundamental difference is that a bull put spread is a credit spread, meaning that you will receive a credit for placing the trade, while a bull call spread is a debit spread, where you must pay a debit to enter the trade. Therefore, a bull put spread is also called a short put spread.
So what does it mean to trade a bull put spread? To answer this question, let’s breakdown the individual components of the trade and analyze them individually. By selling a put option, you are taking on the obligation to accept shares of an underlying at a given strike price. If you are unclear about selling put options, refer to the basics once again. With a short put option position, as the underlying drops in price, the put option gains in value, leading to a loss. This loss is unlimited because the underlying can keep dropping!! To protect against this loss, a lower strike put option is purchased – creating a bull put spread!!
The lower strike put option limits the risk introduced by the sale of a higher strike put. This is the basic explanation behind the workings of a bull put spread!! Here is the risk profile for a sample bull put spread trade:
Let’s say that you are bullish on Apple (AAPL) and after looking at AAPL’s option chain below you decide to sell a put spread. You may be tempted to sell a put option by itself, but remember the unlimited risk issue!! With AAPL at $212, you are of the opinion that the stock will reach $220 within the next 4 weeks.
To take advantage of this move, you sell the 220 strike because as the stock moves up in price, the value of the 220 put option will decrease. Then to limit your downside risk, you purchase a lower strike put option. In this case, let’s look at the 210 put strike. By putting the two together, you have just created a bull put spread!!
By selling a 220 put strike option, you receive a credit of $10.05 and the 210 strike put strike would cost you a debit of $3.15. That leaves you with a net credit of $6.90 [$10.05-$3.15]. You can keep this amount as long as AAPL reaches $220 by expiration. The amount of credit received is the maximum amount of profit you can make on this type of trade!! And since this spread can only be worth $10, the difference between the two strikes (220-210); the maximum risk on this trade is the difference between the spread amount and the max. profit [$10 - $6.90 = $3.10].
Max Profit = Credit Received
Max. Risk (Loss) = Difference between Strike Prices – Credit Received
Once the max. risk is determined, the breakeven point for a bull put spread is just the lower put strike plus the amount of risk. In this case, the breakeven would be $210 + $3.10 or $213.90. Apple would have to reach this point by expiration in order for you to breakeven on the trade.
Breakeven = Long Put Strike + Max. Risk
