3.1 - Bull Put spread- Reason to select

The Bull call spread is another option strategy. It is a two-leg strategy that can be used when the market is moderately bullish. The Bull Put Spread and the Bull Call Spread have the same payoff structure. There are however some differences in strike selection and strategy execution. Bull put spreads are created using 'Put options', not 'Call Options' like bull call spread.

At this stage, a fundamental question may arise- why to choose one over the other strategy between the two if the payoffs are same for both the spread i.e Bull call spread & the Bull Put spread?

This really depends on the attractiveness of premiums. The Bull Call spread can be executed for up to debit the bull put spread is used for credit. If you're at a place in the market that -

1. Markets have been declining significantly, so PUT premiums are up.
2. Volatility is higher
3. There's plenty of time for you to forget.

If you are moderately bullish about the future, it is a good idea to invoke a Bull Put spread for net credit instead of a Bull Call Spread to debit. Personally, I prefer strategies that offer net credit to strategies that offer net debit.

3.2 - Some Strategical Notes

Bull put spread is a traditional two-leg spread strategy that includes OTM and ITM Put options. You can also create the spread with other strikes.

To apply the bull spread -

1. Buy 1 OTM Put option (leg 1)
2. Sell 1 ITM Put option (leg 2)

Do this to ensure:

1. All strikes are part of the same underlying
2. The same expiry series
3. Each leg has the same number options

You can take a look at -

Date - 7 8 December 2015

Outlook - Moderately bullish (expect market to rise).

Nifty Spot – 7805

Trade setup for Bull Put Spread

1. Purchase 7700 PEYou can pay Rs.72/- premium. This is a debit transaction since money is being taken out of my account.
2. Buy 7900 PEYou will be able to receive Rs.163/- in premium. However, this is an ITM option. This is a credit transaction since I get money.
3. The net cash flow, also known as the difference between debit and credit (i.e. 163 - 72), is the sum of the following:+91Since this is a positive cashflow there is a net credit in my account.

A bull put spread generally has a net credit. The bull put spread is sometimes also known as a Credit spread.

The market can move in any direction after we have initiated the trade and it can expire at any level. Let's look at a few scenarios in order to see what the bull put spread would do for different levels.

Scenario 1: Market expires at 7600 (below lower strike price, i.e OTM)

The intrinsic value of the Put options determines their value at expiry. As you may recall, the intrinsic value for a put option at expiry is -

Max [Strike-Spot]

If 7700 PE is used, the intrinsic value would equal -

Max [7700- 7600 – 0]

Max [100, 0, 0]

= 100

We would pay a premium of Rs.72 to be long on the 7700PE, and we would make

= Intrinsic Value – Premium Paid

= 100 - 72

= 28

The 7900 PE option has an intrinsic value equivalent to 300. However, we have sold/written the option for Rs.163

This would be 7900 PE.

163 -300

= -137

The overall strategy payoff would be:

+ 28 - 133.

=- 109

Scenario 2: Market expires at 7700 (at a lower strike price, i.e. the OTM option).

We will lose all our premiums, i.e. Rs.72, because the 7700 PE has no intrinsic value.

The 7900 PE's intrinsic worth will be Rs.200

The strategy's net payoff would be -

Premium ( for selling 7900PE)- Intrinsic value (7900 PE)
- lost Premium (7700PE)

= 163-200 - 72

=- 109

Scenario 3: Market expires at 7900 (at a higher strike price, i.e. ITM option).

Both 7700 PE and 7900PE would have a zero intrinsic value, so both potions would become worthless.

The strategy's net payoff would be -

Premium paid for 7700 PE - Premium received at 7900 PE

= 163 -72

=+ 91

Scenario 4: Market expires at 8000 (above the higher strike prices, i.e. the ITM option).

The options 7700 PE and 7900PE would both expire without value, so the strategy payoff would be total.

Premium paid for 7700 PE - Premium received at 7900 PE

= 163 -72

=+ 91

To summarize -

This analysis should make it clear that 3 things are obvious.

1. As long as the market is moving higher, this strategy will be profitable
2. Regardless of market downturns, the loss is limited to Rs.109. The maximum loss occurs when there is a difference between "Spread and net credit" of the strategy
3. Maximum profit is limited to 91 This is also the case for theNet creditStrategy.

The '" can be defined.Spread"as -

Spread = The difference between the higher and lower strike prices
 

3.3 - More combinations of strike

Keep these things in mind spread the difference between the strike prices is the amount of the spread. The Bull Put Spread is created with one OTM Put and one ITM Put option. However, you can choose any OTM or any ITM strike to create the spread. Spreads are larger if there are more strikes. The potential reward is greater if the spread is larger.

Let's take a look at some examples. Spot is at 7612

Spread Bull Put with 7500 PE (OTM), and 7700 PE(ITM).

Bull Put of 7800 PE (ITM) and 7400 PE (OTM)

Spread Bull Put with 7500 PE (OTM), and 7800 PE(ITM).

The point is that you can create the spread using any combination of OTM or ITM options. The risk-reward ratio will change depending on which strikes you choose and the spread you create. If you are a strong believer in a moderately bullish view, then create a bigger spread. Otherwise, keep it smaller.

Keypoints

1. Alternative to the Bull Call Spread, the Bull Put Spread can be used. This spread is best when the market outlook is moderately bullish.
2. Bull Put Spread results in net credit
3. Bull Put Spreads work best when the market is cracked. Put premiums are high and volatility is higher. You expect the market will hold up (without further cracking).
4. Bull Put is a strategy that involves simultaneously selling an ITM Put option and buying an OTM Put.
5. Maximum profit can only be achieved to the extent that the net credit is available
6. Maximum loss is limited by the Spread minus Net credit
7. Breakeven is calculated using Higher Strike – Net Credit
8. You can spread the word by using any OTM or ITM strike
9. Spreads are correlated with profit potential and breakeven points.