The bull market put spread is a variant of the popular put option selling strategy, in which option investors sell stocks to collect premium income and may buy stocks at a cheaper price. One of the main risks of put options is that investors are obliged to purchase stocks at the strike price of the put option, even if the stock is much lower than the strike price, causing investors to face immediate and substantial losses. Long put option spreads reduce the inherent risk of put options by simultaneously buying put options at a lower price, which reduces the net premium received, but also reduces the risk of short put positions.
Which vertical option spread should you use?
Bull market bearish spread definition
A bull market put spread involves selling or shorting a put option while simultaneously buying another put option (on the same underlying asset) with the same expiration date but a lower strike price. Bullish bearish spreads are one of the four basic types of vertical spreads-the other three are bullish bullish spreads, bearish bullish spreads, and bearish bearish spreads. The premium for short put options with the spread of long puts is always higher than the amount paid for long puts, which means that activating this strategy involves receiving an advance payment or credit. Therefore, bullish bearish spreads are also called credit (bearish) spreads or short-term bearish spreads.
Profit from the bull market’s bearish spread
The bullish bearish spread should be considered in the following situations:
- Earn premium income: When a trader or investor wants to earn a premium income, but the degree of risk is lower than just selling put options, this strategy is an ideal choice.
- Buy stocks at a lower price: The bull market bearish spread is a good way to buy the desired stock at an effective price lower than the current market price.
- Take advantage of sideways to a slightly higher market: Put option and call option spread is the best strategy for sideways trading to slightly higher markets and stocks. Other call strategies, such as buying call options or initiating call spreads, are not effective in such markets.
- Create income in a turbulent market: When the market declines, put options are a risky business because the risk of allocating stocks at unnecessarily high prices is greater. Bull market put spreads can limit downside risks, and put options can be sold even in such markets.
Suppose the stock Bulldozers Inc. trades at $100. An options trader expects it to trade at as high as $103 in one month. Although she wants to sell the stock, she is worried about its potential downside risks. Therefore, the trader writes down three US$100 put options contracts-transaction price of 3 US dollars-will expire within one month, and simultaneously buys three US $97 put options contracts-transaction price of 1 US dollars- It also expires within one month.
Since each option contract represents 100 shares, the net premium income of option traders is:
($3 x 100 x 3) – ($1 x 100 x 3) = $600
(For simplicity, commissions are not included in the calculations below.)
Consider what might happen in the last few minutes of trading on the option expiration date one month from now:
scene one: The bulldozer company’s transaction price is $102.
In this case, both the $100 and $97 put options are at a loss and will be worthless when they expire.
Therefore, the trader can retain the entire net premium of $600 (minus commissions).
The situation where the stock transaction price is higher than the put option exercise price is the best possible scenario for a bull market put spread.
Scene two: Bulldozer company’s transaction price is 98 US dollars.
In this case, the $100 put option adds $2 to the capital, and the $97 put option is outside the capital, so it is worthless.
Therefore, traders have two options: (a) close the short put option for US$2, or (b) buy the stock for US$98 to fulfill the obligation to exercise the short put option.
The former approach is preferable because the latter will generate additional commissions.
Closing a position at US$2 will require an outlay of US$600 (ie US$2 x 3 contracts x 100 shares per contract). Since the trader received a net credit of $600 when he initiated the bull market put spread, the total return was $0.
Therefore, the trader balances the balance of the transaction, but pays out of his own pocket within the commission paid.
Scene 3: The bulldozer company’s transaction price is $93.
In this case, the $100 put option is $7, and the $97 put option is $4.
Therefore, the loss on this position is: [($7 – $4) x 3 x 100] = 900 USD.
But since the trader received 600 USD when the bearish spread was initiated, the net loss = 600 USD-900 USD
=-300 USD (plus commission).
To recap, these are the key calculations related to the bullish bearish spread:
Maximum loss = the difference between the strike price of the put option (i.e. the strike price of the short put option less Strike price of long put option)-net premium received or credit + commission paid
Maximum benefit = net premium or credit received-commission paid
The loss is greatest when the trading price of the stock is lower than the strike price of the put option. Conversely, when the stock transaction price is higher than the strike price of the short put option, the greatest gain will occur.
Breakeven = Strike price of short-selling options-net premium or credit received
In the previous example, the break-even point is 100 USD-2 USD = 98 USD.
The advantage of a bullish bearish spread
- The risk is limited to the difference between the strike prices of short put options and long put options. This means that the risk of huge losses for the position is small, as is the case with a put option written on a falling stock or the market.
- Bull market put spreads take advantage of time decay, which is a very effective factor in options strategies. Since most options either expire or are not exercised, the odds are biased towards the author of the put or the originator of the call-put spread.
- The bullish bearish spread can be tailored according to the individual’s risk profile. A relatively conservative trader may choose a narrow spread that is not much different from the execution price of the put option, because this will reduce the maximum risk and maximum potential return of the position. Aggressive traders may prefer larger spreads to maximize returns, even if it means greater losses if the stock falls.
- Since it is a spread strategy, a bullish put spread will have a lower margin requirement than a put option.
Disadvantages of bullish bearish spreads
- The return of this option strategy is limited. If the strategy is invalid, it may not be enough to justify the risk of loss.
- Before expiration, there is a significant distribution risk for short-selling legs, especially in the case of stock declines. This may result in traders being forced to pay prices much higher than the current market price of the stock. If the strike price of the short put option and the long put option differs greatly in the long put option spread, this risk will be even greater.
- As mentioned earlier, the bullish put option spread works best in a sideways to slightly higher market, which means that the range of optimal market conditions for this strategy is very limited. If the market soars, traders are better to buy call options or use call option spreads; if the market crashes, bull market put spread strategies will usually be unprofitable.
Bull market put spread is a suitable option strategy to generate premium income or buy stocks at an effective price below the market. However, although this strategy has limited risks, its profit potential is also limited, which may limit its attractiveness to relatively mature investors and traders.