According to Aristotle, the ancient Greek astronomer and mathematician, Thales of Miletus once managed to predict that there would be a vast olive harvest in his region, which was strange given the general perception of those around him was quite the opposite. Deciding to bet on the accuracy of his prediction, he decided to try his hand at the olive business. Now Thales was a poor man but a practical one and knew he couldn’t exactly go around buying olive presses in the hopes of striking gold. So he did something different; he bought himself an ‘option’. Thales went around paying small down-payments to the owners of local olive presses, leasing the press from them for the duration of the harvest. His reasoning was simple, yet brilliant.
Since he had no legal obligation to use the presses, all he had done was buy himself the ‘option’ of doing so. Thus, if he was right and the harvest was plentiful, the surge in demand for olive presses would mean that, as the sole owner of olive presses at that time, he would be able to charge exorbitant prices for the use of the same. If he was wrong, and the harvest was a weak one, his only loss would be the small down-payments he’d made to the original owners.
What are Options?
A similar sort of wager has been incorporated in the stock market, and is now referred to as options trading. Options are a derivative financial instrument that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a predetermined price before the contract expires. One of the biggest features of options is that their value is derived from the price of the underlying asset, which means that you need not purchase the asset itself.
Option trading is often used to exercise leverage in investing as they enable you to predict the price movement of the asset in question at a fraction of the cost of actually purchasing the share.
There are majorly two types of options that traders deal in :
- Call Options – This type of contract gives the trader to buy units of a security at a certain price within a specified time period.
- Put Options – These options allow traders to sell units of a security at a predetermined price, within a designated duration of time.
Many traders use options to minimise the overall risk on their trades by hedging their losses. For example, if you possess shares of a company and want to minimise your risk, you can purchase a put option of the same company to sell the stock. This way, if the share price of XYZ Company rises, you gain from the shares you had purchased earlier, and in case the price falls, you recover a portion of your losses from the options trade.
Though it sounds enticing, it doesn’t take much to figure out that if your options expire worthless, you will end up losing the total amount you invested since you don’t possess the asset itself. Considering the complicated nature of options trading, one should be well read and aware of the various strategies that can be deployed to make sure that trading remains profitable.
One of these strategies is to employ a Bull Put Spread.
What is Bull Put Spread?
A Bull Put spread is an options strategy that is used when the investor anticipates a gradual and moderate rise in the price of the underlying asset, within a certain timeframe. The strategy requires 2 put options trades to be placed with the same expiration date.The strategy is to benefit from the range of a high strike price and a low strike price. The investor receives a net credit from the difference between the two premiums from the options.
To execute a bull-put spread strategy, 2 trades need to be made on the same stock:
- Selling an In-the-money Put option with a high strike price
- Buying an out-of-the-money Put option with a low strike price
It is to be noted that both these options should have the same expiration date.
How it works.
Let us see how this strategy can be beneficial through an example.
Let us assume that an investor decides to employ the bull-put spread strategy on a company trading at Rs.95. He purchases a put option at a premium of Rs.15 that comes at a strike price of Rs.80 and expires in August 2020. The investor then places another trade where he/she sells the put option at a strike price of Rs.120 with the same expiration date as the former trade and receives a Premium of Rs.35 on this trade.
It can be ascertained that the net commission he has made from the premiums is Rs.20 as he received Rs.35 on the selling the put option and paid Rs.15 for the purchase.
Let us see the profit he/she would make at the expiration date of the following options :
|Profit from purchase of put option||Profit from sell of put option||Commission earned from premium||Net Profit|
As can be seen by the table, the maximum profit or loss that can be borne by this trade is capped and the maximum profit one can make is the difference in the premiums received and spent at the time of purchasing these options.
When to use it.
Since the profit in these trades is made from the premiums paid and received, it is advised to adopt this strategy when attractive premiums are available. Attractive premiums on put options can usually be seen when markets decline considerably. You should also ensure that there is plenty of time in the expiration dates and the market is looking to move into a mildly bullish trend.To sum it up, the bull-put spread would make for a highly profitable options strategy when attractive premiums are available in the market and you anticipate a moderate rise in the price of the underlying asset.