Bull Put Spread

Underlying Strategy

(Moderately Bullish)(Bullish with an upside target)

When a trader is moderately bullish on the instrument and has a specific target for the price. 

Methodology

The trader buys a PE of a strike price at which she believes the stock shall close above at the time of expiry and sells a PE of a higher strike price at which she expects the price to hit a resistance level.

As the short PE has a higher cost than the long PE, we collect a net premium.The net premium received is (Cost of Short PE-Cost of Long PE ).

However, this strategy gives a limited maximum profit, even if the stock goes outright bullish.

Risk Profile:

This is a low-risk low-profit setup as the loss is limited but the max profit is also capped.The strategy has a pretty good risk-reward ratio in moderately bullish markets.

Margin requirements are high as you are selling a PE.

Calculations:

Max Potential Profit: Net premium received

When: The stock crosses the higher strike price at the time of expiry.

Max Potential Loss: (Strike of Short PE-strike of Long PE)-Net premium received

When: The stock is below the lower strike price at the time of expiry.

Price of Breakeven at expiration: Short PE strike-Net premium received

 Impact with passage of time

The Long PE price has a negative time value while the short PE has a positive time value.

However, the short PE will have a faster time decay than the Long PE.

Hence the net effect of time decay is slightly positive.

Note that the payoff graphs of Bull Call spread and Bull Put spread are same, but time decay works in favor of the Bull Put spread.

This strategy enables you to purchase a call that is at-the-money or slightly out-of-the-money without paying full price. The goal is to obtain the call with strike A for a credit or a very small debit by selling the two calls with strike B and strike C.

 Illustration

 For example, the trader has been following YesBank for around some time and noticed that the stock price is way below its current valuation. Out of the various option strategies, he decides that a Bull Put spread is one that suits him the most, as due to the recent fall in prices the Put premiums have swelled, and wants to take advantage of a net credit strategy.

This strategy is the best for risk-averse traders but requires a higher margin as the trader is shorting an option.

Yesbank is currently trading at 1608. The trader decides to buy 1 lot PE of strike price 1680 of near month expiry, paying a premium of Rs. 63.95 per share., and then sells 1 lot PE of strike price 1680 receiving a premium of 78 per share. The strategy is

Long PE of Strike Price 1680 : Premium=63.95

Short PE of strike price 1700 :Premium=78

The net premium received  is then

78-63.95)*LotSize=14.05*350=Rs.4917

This net premium received is the maximum profit which the trader can make using this strategy.

Let us consider the black line viz. 1700 CE as Option A and the green line viz.

1680 PE as Option B.

Orange Line is the total profit for the strategy.

Maximum profit occurs when both of the Put options become worthless at the time of expiry.

Above 1700, both PE would have an Intrinsic value of 0. Therefore the trader will achieve a maximum profit of net premium received viz. 4917

Now let us consider different scenarios for the strategy

Stock closes at Rs.1600

Value of Option A=100

Value of Option B=80

Net profit in Option A=(Premium-Value)*Lotsize

=(78-100)*350

=-Rs. 7700

Net profit in Option B= ( Value-Premium)*LotSize

=(80-63.95)*350

= 5617

Net Profit= 5617-7700= -Rs 2082

Stock closes at Rs.1690

Value of Option A=10

Value of Option B=0

Net profit in Option A=(Premium-Value)*Lotsize

=(78-10)*350

=Rs. 23800

Net profit in Option B= ( Value-Premium)*LotSize

=(0-63.95)*350

= -Rs.22382

Net Profit=23800-22382=Rs. 1418

 Stock closes at Rs.1720

Value of Option A=0

Value of Option B=0

Net profit in Option A=(Premium-Value)*Lotsize

=(78-0)*350

=Rs. 27300

Net profit in Option B= ( Value-Premium)*LotSize

=(0-63.95)*350

= -Rs.22382

Net Profit= 27300-22382=4918