Bull put credit spreads are strategies that are designed to profit from a directional move up in the underlying stock and a drop in implied volatility. These are high probability strategies where you are a net seller of options below the market price and are looking for the options to decay in value and become worthless at expiration.
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In this video tutorial, we’re going to talk about the bull put spread. Starting with the market outlook, as always, this is a little bit of a complex options strategy.
It’s not the most complex, but it’s not just your simple run-of-the-mill buying and selling of puts and calls. The bull put spread option is entered when the options trader thinks that the price of the underlying asset will go up moderately in the near term.
We’re not all too crazy about being bullishness. We just think that there’s going to be a general rise in the price. We don’t think it's going to double in price in the next 30 to 60 days.
Now traditionally, this is known as a put credit spread since credit is received upon entering the trade and then you hope you keep that entire credit at expiration. Sorry for the typo there. This could be considered one of your credit spread strategies, in this case, a put credit spread.
How do you set this up? It’s very easy. It only takes two options to setup this particular strategy, but this is where the beauty of creating a strategy around the market comes into with options.
Bull put spreads are implemented by selling an at the money put while simultaneously writing a lower strike out of the money put on the same underlying security and the same expiration month.
Very key there that the same expiration month. In this example to the left with our profit loss diagram, you're going to sell one 45 strikes put, and then you're going to buy one 40 strikes put, so you’re going to sell the in the money and buy the out of the money.
Now, you can do this with two out of the money options. The key is that you want to sell the higher priced put and you want to buy the lower priced put when you’re doing a bull put spread, or a bull put credit spread.
That's the real key there. These could be all in the money, at the money, all out of the money. The key is that you want to sell the higher strike and you want to buy the lower strike.
What’s the risk with this strategy? Well, as you can see here on the chart, the maximum loss on this strategy is limited. The difference between the strikes less the credit received, so the difference between your strike prices, 45 to 40, less the credit that you receive on this, that is the maximum loss that you can take in.
The worse that can happen is for the stock to close lower than the lower strike at expiration. This lower strike here where the loss diagram starts the flat line here, your losses are capped right here at $300.
Anything below 40, if the stock closes anywhere below 40, then your losses are completely and 100% capped, you cannot lose a dime more. Because in that case, both put options expire in the money which creates the loss.
If we talk about profit potential now, we also notice that the top half of our profit loss diagram is also flat, meaning it's capped to the upside, it doesn’t continue on in perpetuity. The maximum gain on these is capped.
The ideal scenario would be to see the stock close above the higher strike price, so anywhere from 45 higher, in which case, both put options expire worthlessly and you pocket the credit.
Remember that a bull put spread is just a credit spread. It’s just a put credit spread. With a credit spread and any options strategy where you receive a credit initially, you do want all of those options to ideally expire worthless, in which case, you keep 100% of that credit.
Closing between the strikes though results in variable gains or losses. If we close anywhere along this diagonal line here, you could have a loss, or you could have a small gain either one. When we talk about volatility, volatility on this particular strategy is going to be fairly low.
Since the strategy involves being long one put and short one put of the same expiration period, the effects of volatility are going to offset each other to a large degree. If you have a positive volatility move here and a negative volatility move here, for more or less, they’re going to offset each other.
There is going to be a slight difference because you are selling and buying at different strike prices, but it’s only going to be a very small difference. You’re going to have a greater impact on the actual underlying price of the stock.
With time decay, it's the same sort of thing as volatility. The passage of time decay is going to help the strategy since it is a short option strategy or an option selling strategy and we do want all the options to expire worthless at expiration.
But just like volatility, with two put options, the effects of time decay on both contracts are going to offset each other. Where you gain money and time decay on one option, you’re going to lose it on the other one more or less.
With breakeven points on this bull put spread, the strategy breaks even if at expiration, the stock price is below the upper strike (this is the short strike price or the short put option) by the amount of the initial premium.
You can see that our strike price on the upper strike is 45, so the breakeven point would be 45 less the initial premium that we received. That would create this area here at 43 which would be virtually where our option breaks even. Let’s look at an example just to drive it home here.
We have a stock price that’s trading at about 43, so let’s just say the stock is trading right here. We’re going to buy one 40 strikes put for $100, (again, down here) we’re going to buy this one for $100, and we’re going to sell this one 45 strike put for $300.
The net difference between those two (we outlaid $100, we took in $300) is a credit or money that we received directly into our account of $200. And you can see that that is where our profit is capped on the topside.
Now, our max loss is $300. It’s the strike price minus the credit, so 45 minus 200 is going to be that $300 loss. Oh, this maximum profit is not calculated correctly, but our maximum profit is $200 or the net credit that we received.
Some tips and tricks for a bull put spreads or bull put credit spreads: The more out of the money your strike price is, the more conservative your position. In this example, we sold this strategy here right at the money, but you don’t have to do that.
If the market is trading at 43, you can sell these all the way out possibly down to 20, 25, in that type of area. Higher credits don't necessarily mean it’s a better position to have.
Generally speaking, you’re going to see an at the money position that’s basically a 50-50 flip where you’re going to make about the same as you’re going to lose. It's just the same as trading the underlying stock.
You do want to have some direction on the market and have some opinion. You don’t just want to trade these and think you’re going to take in money every time, but you want to have some direction on the market.
The more out of the money you are, the less your credit is going to be or the less premium you’re going to receive, but the more likelihood is you’re going to keep that premium since it’s far out of the money. If you’re having trouble filling these positions, try legging into the spread.
A lot of options brokers will try to have you enter these at the same time, so it’ll have you simultaneously place an order to sell the 45 and simultaneously place an order to buy the 40.
And when you do that, you have to have exact fills on all of those. But try legging into it, so you buy or sell individually these legs and create the position by the end of the day.
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