- Bull put spread is an option strategy used by traders to cap their maximum loss.
- At first, a trader is bullish with the upside capped, so he initiates an ITM sell put option, i.e., the strike price is higher than the spot price.
- In a sell put option, maximum profit is fixed, which is equal to the premium received and the maximum loss is unlimited.
- If the price rises as he expects, the maximum profit will be the premium received.
- However, the trader later observes a resistance level at the top and expects the trend to be bearish.
- Suppose the trader’s worry became true and the price started to revert back from the resistance. The trader will fall into huge loss.
- To reduce his loss, he initiated an ITM buy put option, such that the strike price of the buy put option is less than the strike price of the sell put option.
- In this case, the trader receives a higher premium for the sell put option than he pays to the buy put option.
- If the price rises, the trader would incur a profit in the sell put option but at the same time incur a loss in the buy put option.
- Since the gain is higher than the loss, the profit is now limited and it is equal to the difference between the premium received and the premium paid.
- If the price falls, the trader would incur a loss in the sell put option but at the same time incur a profit in the buy put option. Since the loss is higher than the gain, the loss is now limited.
- This way, the trader reduced his maximum loss, from unlimited to limited.
Consider an example: a trader initiated a bull put spread option strategy
Short Put: Strike Price = 1050 & Premium Received = 40
Long Put: Strike Price = 1000 & Premium Paid = 30
Here, P/L = Profit/Loss
The graph clearly depicts the difference between a short put option and a bull put spread option.
In the second strategy, the maximum loss is limited.