Picking the right stock, picking the right direction, and picking the right time to buy or sell can sometimes be difficult. This is why, if you are familiar with the unique aspects and risks associated with options and are bullish about an investment over a specific period of time but want to limit your risk exposure, you may want to consider a bull put spread.
A bull put spread offers limited risk, while giving you different ways to profit from volatility in the underlying asset. This strategy is particularly attractive for assets that are expected to rise slightly, may fall slightly, or may remain unchanged, and when volatility—the level of uncertainty in the market or a specific security—is high.
Establishing a bull put spread is relatively straightforward: Sell one put option (short put) while simultaneously buying another put option (long put).
A bull put spread is also known as a vertical spread strategy (buying and selling options of the same underlying asset and expiration date) and a credit spread (you receive money at the outset of creating the position, and this is the maximum profit for the position). Because you are selling one put option and buying another, you are effectively hedging your position. The result is that potential gains and losses are capped.
When this strategy works
The bull put spread is used if you are moderately bullish on a stock or index, and your preference is to limit risk exposure. The primary goal is to make a short-term profit while limiting risk. You want the underlying asset (stock, index, etc.) to rise above both put options so they are out of the money (strike price is below the current market price), and the contracts expire worthless. If the options expire, you keep the credit you received.
What to look for before you initiate the trade
Before you initiate a bull put spread, it’s important to know what to look for. Here’s some helpful guidance:
Tools to use
A valuable set of tools at your disposal when trading options are Greeks (i.e., delta, gamma, theta, vega, and rho).* Using Greeks can help you forecast how changes in price, time, and volatility can affect the value of your spreads.
Once your position is initiated, you should monitor it closely as you might need to take action before the contracts expire. The goal is to have both legs (each side of the spread—the buy side and the sell side) expire worthless to earn the maximum profit potential.
Bull put trade in action
Now that you have a basic idea of how this strategy works, let’s look at an example and a few specific scenarios.
Now, let’s look closely at what could hypothetically go right or wrong:
A winning trade: The underlying stock, XYZ, stays above the $32 strike price at the expiration date.
If the underlying stock stays above $32 at or before expiration, both puts remain out of the money and will expire worthless and you get to keep the premiums, minus transaction costs.
Trading options with Fidelity
Before creating a spread, you must fill out an options agreement and be approved for a Level 3 options account. Contact your Fidelity representative if you have questions.
Assuming you want to exit the trade based on your strategy, you have a couple of options if you want to close the trade out in this scenario. First, you can close both legs of the trade. In the above example, if you enter a limit order, an order is placed to buy to close the short put for $90, and sell to close the long put for $40. Your profit is $40: $90 (your original credit) minus $50 ($90 for short put minus $40 for long put).
Second, if both options are out of the money, you can consider letting both legs expire worthless, achieving maximum profit. Depending on your specific risk and return objectives, you may want to consider closing both legs of the spread before expiration, once your profit goals are reached.
A losing trade: The underlying stock, XYZ, drops below the $32 strike price before the expiration date.
If the underlying stock drops below $30, and the option becomes in the money on or before expiration, both puts may rise in value. This is not what you expected or wanted. Your goal was to keep as much as possible of the $90 credit you originally received.
However, you should be prepared with a plan for exiting any strategy when things don’t quite go your way. Although the short put is costing you money, you are protected from the potentially substantial loss of that position by the long put. Nevertheless, in this scenario (both options are in the money), you can lose the maximum, or $110, if the stock drops below $30.
It is worth looking at an example to see how you might close a losing trade like this, assuming you no longer want to be in the position. The short put might rise from $3.50 to $4.80, while the long put could rise from $2.60 to $3.20. Before expiration, you could close both legs. You would place an order to buy to close the short put for $480, and sell to close the long put for $320.
In this example, you must pay $160 to exit the position ($480−$320), but you previously received a credit of $90. As a result, your total loss is a more manageable $70.
If you wait until expiration, you could lose the entire $110. Depending on your risk tolerance and objectives for the trade, you might choose to close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated.
Options traders should always be aware of early assignment, as well. There's a chance you’ll be assigned early (before expiration) on the short put. Actively monitor your option positions and learn to manage risk.
Next steps to consider
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