Playbook: Spreads: the Bull Put

Bull Put

The bull put (or ‘put credit spread’) is a vertical credit spread (you will receive a premium for it). It is a short put ‘protected’ on the downside by a long put.

Put credit spreads/bull puts are a way of getting long shares with limited risk.

The short put you buy is OTM, but closer to the underlying price, so earns more money than the further OTM long put for which you have to pay (the further you go OTM, the cheaper the option). Therefore it is a ‘credit play’ (you get a fee for the set-up).

You typically buy a bull put around 45 days before expiration (45 DTE).

The bull put is the opposite of the bear call.

The position benefits most from IV/IVR contraction and/or increases to/above the short put. So you benefit from low volatility once you are in the trade.

Considerations

General

These are the considerations for entering a bull put:

• The expectation that underlying (stock, ETF, index, future) will go up or sideways (‘rangebound’): the outlook is neutral to bullish.
• Not interested in buying calls.
• Selling premium is expensive.
• Implied Volatility (IV)/IVR (IV Rank) is high(>30), looking for options to decrease in value over time*
• You can make a better return than if you had bought the underlying itself.
• Executing a bullish trade for income at reduced maximum risk because you buy a put (‘insurance’, protection at the downside) as well.
• It’s difficult to sell (‘short’) premium, so it is a leveraged alternative to selling/shorting the underlying.
• Bringing down the cost, risk, and breakeven on the trade compared to selling (only) the short put: by collecting option premium (‘credit’), the position profits from both time decay (theta) and increasing underlying prices, at limited risk.
• The underlying has just experienced a decline, which gives you a strong entry.
• Hedging against bearish positions.
• Risk is limited (‘defined’) to the difference between the strikes minus the premium received (‘credit’).
• The maximum reward is capped to the premium received (‘credit’).

* Note: because you’re both buying and selling a put, the potential effect of a decrease in implied volatility will be somewhat neutralized.

Description

Set-Up

1. ‘Sell to open’ (‘STO’) the put option OTM at 0.30 delta, so below the underlying price (or over 10% ‘cushion’ below the underlying price).
2. ‘ Buy to open’ (BTO) the lower put option ( in US 1 contract = 100 shares) OTM at 0.10 delta (or over 10% cushion from higher strike).

• Sell the same number of strikes.
• Both puts should be lower than the current underlying price to ensure a profit even if the underlying doesn’t move at all.
• Arrange both put strikes to collect a credit of at least 1/3 the width of the spread (while taking into account the deltas/cushions).
• 70% PoP/P50 (probability 50% profit).
• Spreads with higher deltas are more sensitive to underlying price changes, are better equipped for management, and improve risk/reward.
• Look at taking advantage of volatility skew: the differential between option prices based on implied volatility: selling OTM options with higher premium/credit, while at the same time purchasing ATM/ITM options at reduced premium/debit, resulting in higher net credits.

Related Options Strategies

The bull put combines a short put with a long put at the same expiration date, and is one of the four vertical spread strategies (the other ones are: bull call, bear call, and bear put) and the basis for many other strategies, like short condors, and butterflies.

The Greeks

GREEK

+/-

Notes

Profile

Delta (direction speed)

+

Delta (speed) is positive and is at its fastest in between the strikes. Notice how Delta slows down when the position is deep ITM or OTM

Gamma (acceleration)

+

±

Gamma (acceleration) peaks below the lower (bought) strike and peaks inversely above the higher (sold) strike.

Theta (time decay)

+

±

Time decay is helpful to the position when
it is profitable and harmful when it is not.

Vega (volatility)

+

±

Volatility is helpful to the position when it is OTM and harmful when it is ITM.

Rho (interest)

+

Higher interest rates are generally helpful to the position

Entry Rules

Profitable bull puts require correctly selecting bullish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR above 30%.
• Ensure the trend is up/bullish (or at least rangebound/sideways).
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bullish
2. Support & Resistance = the underlying has just experienced a decrease to a clear support level
3. RSI = oversold
4. Bollinger Bands in combination with Keltner Squeeze: at the bottom and outside Keltner bands
5. ADX/DMI: increasing up and above 20
6. ATR high

P/L and Risk Profile

Net Position

Net credit, because you receive a premium for selling the put option.

Theoretical Profit

The maximum reward is the net credit, realized when the price of the underlying is at/above the short put.

As the stock price goes up, the Bull Put moves into profit and reaches the maximum profit when the stock remains above the higher strike price.

Both puts will expire worthless, and you keep the net credit.

Theoretical Risk/Risk Profile

As the stock price falls, the Bull Put moves into loss and reaches the maximum loss when the stock falls to the lower
strike price.

The maximum risk is the difference between the strikes -/- the net credit received for selling the short put, realized if the underlying price is below the long put.

Breakeven

Underlying short put strike -/- net put premium/credit.

Managing and Closing Position

Halfway to/Near Expiration

• If the underlying price is close to/above the short put (higher strike), profits increase because the short put is closer to the money and decreases in value faster than the long put.
• If the underlying price increases to/slightly above the short put (higher strike): both puts are OTM and expire worthless and the profit = net credit (‘theoretical profit’).
• If the underlying is between the put strikes and decreases towards the long put (lower strike), the losses increase, because the long put is now closer to the money and increases in value faster than the short put.
• If the underlying decreases to the long put: losses increase because the long put is closest to the money and decreases in value faster than the short put
• If the underlying decreases below the long put (lower strike): the maximum loss will be the difference between strikes -/- net credit (theoretical risk).

Rules for Managing/Adjusting Position

• If the PoP is <33%
• If the underlying price decreases there are different ways o manage the position:
  • Roll the tested or breached short put down for extra credit (same expiration) when the short strike is ATM/slightly ITM, but never below breakeven (‘defensive roll’ and always check with your rules – like IVR >30 – and backtest to decide whether you would also have done this as a new set-up.
  • Roll the position out in time when the short strike is ATM or slightly ITM (‘vertical roll’), and the long strike is OTM, to extend the duration and the breakeven, and to continue the original strategy.
  • Convert it to an Iron Condor by selling a Bear Call (however, you are creating upside risk and the natural tendency of many underlyings over time is to have a bullish bias), if you feel that the underlying will rebound, but want to give it a bit more time. Note: ‘invert spreads for a credit greater than the width of the inversion, as long as the underlying price remains within the short strikes (spread).
  • Convert the put credit spread into a Butterfly by adding a put debit spread (so you now have two short puts at same strike), if you don’t really feel that the underlying will rebound and move to the upside, but still want to stay “in the game” (however, it usually requires staying in very close to expiration to reap the benefits, and therefore is also called a “Time Bomb Butterfly”).
  • Or invert the spreads for a credit greater than the width of the conversion, as long as the underlying price remains within the short strikes (spread)
  • If this is not workable: allow the limited risk probabilities to play out, or close the position.
• Set alerts on breakeven/predetermined targets.

Rules for Closing Position/Exiting the Trade

• Unravel the spread by buying back the puts you sold and selling the puts you bought (this is actually similar to buying a bear put).
• Close for a 50% profit.
• Close before the final month before expirations (to avoid volatility going up), so not later than around 21 DTE.
• You can also decide to close leg-by-leg and leave one leg open if you expect to profit from that.

Mitigating a loss

• To hedge/recover losses you open a high probability position, using a strategy that favors neutralizing the portfolio’s ∆β, to rebalance and create an overall statistical edge, reduce costs or maintain profits (this is always the goals when adding risk to manage limited risk strategies).
• Unravel the spread by buying back the puts you sold and selling the puts you bought (this is actually similar to buying a bear put).
• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% of the premium paid. However, for narrow spreads there isn’t much difference in letting the play go into expiry or doing a stop-loss (say at 2x premium): see this video on TastyLive.

Additional Notes

Advantages

• Short-term income strategy not necessarily requiring any movement of the stock.
• Capped downside protection compared to a naked put.

Disadvantages

• Maximum loss is typically greater than the maximum gain, despite the capped downside.
• High-yielding trades tend to mean less protective cushion and are therefore riskier.
• Capped upside if the stock goes up.

Exercise/Assignment

The short put can be assigned in the event it is ITM. This results in (probably unwanted) stock.

The risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put (lower strike) in a bull put spread has no risk of early assignment, the short put (higher strike) does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bull put spread (the higher strike), an assessment must be made if an early assignment is likely. If the assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before an assignment occurs, the risk of assignment can be eliminated in two ways.

1. The entire spread can be closed by buying the short put to close and selling the long put to close as a single Covered Stock order.
2. The short put can be purchased to close, and the long put open can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put.

Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Source: Fidelity Learning Centre

The long put can be ‘exercised’. For this, you need to contact your broker.