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Old 02-23-2012, 11:01 PM   #1

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Bull Put Spread

Traders who use a bull put spread strategy are betting that the market price of the underlying asset will go up moderately or substantially. The strategy involves a selling put, and hedging it, by buying the same quantity of put options. The trader hopes that both options will expire Out-of-The-Money (OTM), allowing him or her to keep the premiums. Investors sometimes call a bull put spread strategy a credit spread, since premiums received from the put sale are larger than the cost of buying the put. Investors use this strategy to limit any potential losses. At the same time, the maximum profit an investor can gain is the amount of premiums the he or she collects.

How to Enter a Bull Put Spread
A trader must perform two operations at the same time to enter a bull put spread.
Example: XYZ is trading at $43

Selling a Put
First, the trader will sell a naked put that's In-The-Money (ITM).
1) Trader writes (sells) put option: XYZJan45 ($3)
- One Option = 100 shares of XYZ stock
- Strike Price $45/per share, expiring on 1/15
- Premium Cost of $3.
2) Trader sells one put option and receives $300 [100 x $3 (premium cost)].

Buying a Put
Next, a trader will need to buy a put that's Out-Of-The-Money (OTM).
1) Put Option Available: XYZJan40 ($1)
- One Option = 100 shares of XYZ stock
- Strike Price $40/per share, expiring on 1/15
- Premium Cost of $1.
2) Trader buys one put option and pays $100 [100 x $1 (premium cost)].

Result: The trader is in the options market with a $200 credit in his or her account (Amount Received $300-$100 Amount paid).

Advantage and Disadvantage of Bull Put Spread

Pluses: The upside to this type of strategy is that the investor limits their losses. The most that a trader can lose will depend on the strike price of the put and buy orders.

Minuses: The downside in using a bull put spread is that the investor's profit is also limited. The most that a trader can gain is what he or she collects in premiums after the buy and sell orders expire worthless.

Examples Using the Buy and Sell Orders Above:

Example: XYZ is trading at $43
XYZ Market price increases to $46.
Result: Both the buy and sell put orders will expire OTM. The investor keeps the $200 credit in his or her account, collected from premiums when entering the market.

XYZ Market price declines to $38.
Sell Order Result: The option expires ITM. The trader buys 100 shares to cover the put, and pays $4500 to whoever bought the option.
Buy Order Result: The option expires ITM. The trader exercises their right to sell 100 shares at $40, and receives $4000.
Total result: Trader pays $4500(from sale order) - receives $4000(from buy order) + $200 (credit in account) = $300 loss. This amount is also the most the trader can lose on this investment.

Choosing the Correct Strike Price
Looking at the example above, one can see that the strike price plays a significant role in limiting losses from a bull put spread. Only expert traders should buy puts with strike prices closer to market prices when implementing a bull put spread strategy. Choosing an ATM buy order, instead of one that's OTM may reduce an investor's loss, but the person also takes on more risk, as strike prices closer from market prices, may not expire OTM.
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