Credit/Credit Spread Strategy:
Bull Put Spread

ANALOGY/METAPHOR: Being an Insurance Company - Insuring Shareholders Against Defined Drops in a Stock's Share Price

ACTION: The bull put spread consists of simultaneously writing 1 out of the money (OTM) put and purchasing 1 farther out of the money (FOTM) put for a net credit. The maximum gain is the total amount of net credit received if the share price finishes above the higher strike price. The risk of loss is equivalent to the "spread" in dollar value between the two strike prices, which would occur if the stock closed at or below the lower strike price.

DESCRIPTION: With the bull put spread, you are essentially an insurance company insuring a specific stock in anothers investor's portfolio from a drop in share price. There are three variables in a bull put spread: what price you're insuring the stock at (strike price); how long the coverage period is (expiration date), and how much income or compensation you collect (net premium).

Additionally, like any self-respecting insurance company, you purchase reinsurance to protect yourself in case of a catastrophic event. With the bull put spread you do this by buying a put option at a strike price lower than the strike price of the put option you initially sold to collect your premium. Since the second option is cheaper than the first option, you still walk away with a net credit and your maximum loss is the difference between the two strike prices (times 100, of course, since each contract represents 100 shares).

EXAMPLE: The XYZ Zipper Company is trading at $32/share. You feel confident that it will stay above $30/share in the near term. You consult the option chains on the stock and decide to employ a Bull Put Spread option trading strategy.

You simultaneously sell a put at the $30 strike price with an expiration date two months out for $1/contract, and purchase a put at the $27.50 strike price with the same expiration date for $0.50/contract. Excluding commissions, you receive a net credit of $.50/contract, or $50 ($1 less $0.50).

The possible outcomes:

• The stock finishes above $30/share. Both puts expire worthless and your proceeds are the full amount of your original net credit. In this example, that's $50, or a 25% return ($50 divided by the $250 capital amount required, which is calculated by the difference between the $30 and $27.50 strike prices).

• The stock finishes between $27.50/share and $30/share. The $27.50 put expires worthless, but the $30 put finishes in the money (ITM). Your original net credit is reduced by the amount the $30 put is ITM. Because of the $0.50 initial net credit, you don't actually begin losing money until the stock falls below $29.50/share.

• The stock finishes below $27.50/share. You lose the maximum amount possible on this trade, in this case $200. You lose $250 on the difference between the strike prices (both options expire ITM and consist fully of intrinsic value), but because you received $50 in premium at the outset, your maximum loss will be $200.

VARIATIONS: by adding a bear call spread on the same stock with the same expiration date as your bull put spread, you turn the position into an iron condor.

OTHER: Advantages and Disadvantages -

Advantages (over naked puts and/or cash secured puts)

The first advantage is that the bull put spread limits your potential loss to the difference between the strike prices of your short and long put. If you employed naked puts in the example above, where XYZ is trading at $32.50/share, and you wrote your initial put option at the $30 strike price, if the stock went all the way down to zero, your loss is $3000, less the premium you received. With the bull put spread, however, although your premium would be less, the maximum you could lose is $250, less the net premium you received.

The second advantage is that your capital requirements are much, much less. Writing a cash secured put essentially requires that you have enough cash on hand to purchase the entire position should the option be assigned. With the bull put spread, your capital requirement is simply the spread between the two different strike prices. In the example above, the spread is $2.50 ($30 short put and $27.50 long put), or $250. That's a whole lot less than the $2750 required to set up a comparable cash secured put position.

Disadvantages (compared to naked puts and/or cash secured puts)

OK, there's only one disadvantage, but it's so potentially enormous that it should count for at least three or four regular disadvantages.

The primary drawback is that it invites abuse as a trader almost always over-leverages. The twin advantages listed above, when aggressively exploited, can easily be turned into a lethal combination. And I don't mean lethal to the stock market--I mean lethal to you.

To continue using our example above, if you need $2750 to write a single naked or cash secured put but only $250 to set up a Bull Put Spread, it won't take long before you realize you can write 11 bull put spreads for every naked or cash secured put. Wow--you can make a hell of a lot of money doing this, both on a percentage basis and in real dollars.

The problem occurs when the stock really moves against you. What if it gaps down to $25/share one morning on some unexpected bad news? With naked puts, the potential loss, although unpleasant, is sustainable when you've got the cash or margin to cover being assigned. Maybe the stock decline is a short term event and you're willing to hold the underlying security, confident that the stock will rise in the intermediate term. Perhaps there's even a dividend involved that pays you something to wait.

But with the bull put spread, it's customary to trade far more contracts than you're ever capable of holding should you be assigned. Yes, actual assignment is unlikely and besides, your long put at the lower strike price hedges you as designed, but over-leveraging completely eliminates the original benefit of limiting your potential losses.

Final Thoughts