Exchange-traded funds (“ETFs”) provide investors with an easy way to reach virtually every corner of the stock market with a single U.S.-traded security. But, those looking to further enhance their trading by limiting risk and/or leveraging profits can take advantage of equity/stock options trading on many of these ETFs [see ETF Call And Put Options Explained].
In this article, we’ll discuss how the bull put spread can be used to profit from a modest rise in an ETF’s share price, while limiting maximum potential losses.
What Is the Bull Put Spread Strategy?
Suppose that you believe that the S&P 500 SPDR (SPY, A) will rebound after a recent fall in share price, but there’s still a risk that the index could breakdown lower. Simply purchasing the ETF risks losing unlimited amounts of money in this downturn, while purchasing call options involves putting up capital right away that could result in some opportunity costs [see also ETF Covered Call Options Strategy Explained].
The bull put spread offers an alternative that provides a net credit, while tightly controlling potential risks and rewards. By purchasing one out-of-the-money put option and selling one in-the-money put option, you can receive an immediate income with the maximum potential loss simply being the difference between the two strike prices.
Here’s what the profit/loss diagram looks like:
Who Is The Bull Put Spread Strategy Right For?
The bull put spread strategy is ideal for investors who are moderately bullish on an ETF, but not bullish enough to purchase the underlying stock or call options alone. While there’s some upside potential sacrificed, investors receive all of their potential profit on the front-end of the trade, enabling them to reinvest into the market with no opportunity costs.
The strategy works best in situations where the underlying stock appreciates only modestly in value above the higher strike price. Moreover, the strategy is ideal for stocks that may have an upcoming potentially bearish catalyst or in situations where the investor doesn’t want capital tied up, since loss potential is limited and the profit is realized right away.
What Are the Risks/Rewards?
The bull put spread strategy has a very well defined risk to reward profile, given that the options create a spread rather than take a net long or short position. The key breakeven point for the underlying stock that investors need to be concerned with is calculated by subtracting net premiums received from the strike price of the short put option [see also How To Hedge With ETFs].
The maximum profit and loss potential is calculated as follows:
- Maximum profit is equal to the premiums received when the investor first enters into the position minus any commissions paid to a broker.
- Maximum loss is equal to the difference between the strike price of the short put option and the strike price of the long put option plus commissions paid to a broker and minus the net premiums received when first entering into the position.
How to Use a Bull Put Spread Strategy
Using the scenario mentioned earlier, suppose that you establish a bull put spread on the S&P 500 SPDR ETF when it’s trading at 165.00. You decide to enter into the position by selling one 170.00 put option for $5.00 and then buying one 160.00 put option for $1.00, resulting in a net credit spread of $400.00 at the onset of the position – the total profit potential [see How To Take Profits And Cut Losses When Trading ETFs].
The breakeven point of this position is then the strike price of the short put option – $170.00 – minus the $4.00 net premium received – or $166.00 per share.
Here are the possible scenarios that could play out:
|170||$500-$100 = $400|
|=165||$500-$100-$500 = -$100|
- Bullish – The ETF rises to $170.00 per share and both options expire worthless, resulting in the $400 in premiums booked as profit.
- Neutral – The ETF remains at $165.00 per share and the 170.00 put option expires in-the-money, resulting in a $500 loss that’s offset by the $400 in premiums.
- Bearish – The ETF falls below $160.00 per share and both put options expire in-the-money. Since they offset each other below the lower 160.00 strike, your losses are limited to the difference of $1,000 minus the $400 in premiums, or a $600 loss.
The Bottom Line
ETF investors looking for a moderately bullish strategy may want to consider bull put spreads as a way to bet on upside with a well-defined risk to reward profile. Moreover, the strategy enables investors to realize the profits upfront, which can then be reinvested in other opportunities that may be available in the market.
Investors seeking a more bullish strategy may want to instead consider purchasing the underlying stock or call options. While these strategies have higher loss potential, their profit potential is unlimited, leaving significant room for appreciation.
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Disclosure: No positions at time of writing.
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