Risk Management for Bull Put Spread Strategy

A bull put spread is a type of options strategy used by investors who anticipate a moderate rise or at least stability in the price of the underlying asset. In this strategy, the investor sells a put option with a higher strike price while simultaneously buying a put option with a lower strike price, both with the same expiration date.

If the price of the underlying asset remains above the higher strike price at expiration, both options expire worthless, and the investor keeps the premium received. However, if the price falls below the lower strike price, the investor may incur losses, which are limited to the difference between the two strike prices minus the net premium received. Overall, the bull put spread strategy is used to capitalize on a bullish or neutral market outlook with limited risk.

Reference [1] examines the effectiveness of stop losses in bull put spreads. This is achieved through Monte Carlo simulation, which is conducted in an idealized setting using theoretical asset and option prices. Although the simulation may not perfectly reflect real-world conditions, it provides valuable insights and intuitions regarding the effectiveness of different stop-loss strategies. The author pointed out,

While all three strategies with strict exit variants show a clearly (exponentially) positive development, an (almost) total loss has completely destroyed the variant with no exit strategy. Since a (near) total loss event practically erodes the entire investment, a realistic chance of recovery is no longer possible. Seen from this perspective, it becomes much clearer, much more so than could be seen from the computations of average returns, that implementing a bull put spread strategy in the setting we chose (using the available investment to the full) proves fatal without a strict exit strategy.

Upon reviewing the results presented in Table 4.12, we notice some counterintuitive findings,

• Firstly, the strategy proves profitable only during periods of low volatility;

• Conversely, it incurs losses when volatility is high, even during a bull market. (We believe that we have insights into why it loses money in a bull market, but we leave this to the readers).

• The implementation of stop losses enhances the strategy’s performance.

The author’s conclusion emphasizes the importance of common-sense principles and best practices in portfolio management, such as capital preservation and minimization of the risk of ruin. These objectives can be achieved through the implementation of stop losses.

We note, however, that the risk of ruin can also be minimized by eliminating the tail risk. This is our preferred solution.

Let us know what you think in the comments below.

References

[1] Gerhard Larcher, The Art of Quantitative Finance Vol.1, Trading, Derivatives and Basic Concepts, 2023, Springer