<< Basic Option Spread Strategies (Part 2) - Bear Put Spread

Bull Put Spread

Step 1: Sell higher-strike Put option
Step 2: Buy lower-strike Put option with the same expiration date

Characteristics
A Vertical Spread, this is a Credit Transaction

Investor Sentiment
Moderate Bullish Strategy (large credit spread):
It’s considered a bullish strategy because you
profit if the underlying stock price increases.

Income, Profit & Loss
Net credit = Higher-strike put options – lower-strike put options
Profit = Net credit received (maximum; limited)
Loss = Difference between strike prices – net credit (maximum; limited)

Profit Potential
Maximum profit is the net credit received if the stock price closes above the short (higher) put option strike price on expiration date.

Risks
Maximum loss occurs if the stock price decreases below the out-of-the-money, long (lower) put option strike price at expiration date.

Drawbacks
Limited profit potential, but lower risk than strictly selling a naked put option. Break even at upper strike price minus net credit. Similar to a Bear Call Spread, this strategy is a credit spread position. That is, the amount of the sale of the put option position brings in more than is required to buy the long one.

How To Trade
Many traders regard this trade an income strategy. You trade a bull put spread in circumstances where you anticipate the underlying asset price to either rise or at least not fall below the level of the higher-strike price selected. You are looking for very strong support such as a confirmed double bottom or triple bottom and other technical reversal patterns.

For Bull Put Spread to work as a short-term strategy, you generally want to select both strike prices to be below the current stock price and the spread between two strikes to be tighter – say one strike price apart.

Time decay is helpful in this position and the safest period to trade is one month to expiration date. This will give the opposite side of the trade little time to be right.

Bull Put Spread Example

Stock Company Name/Ticker Symbol: Int’l Business Machine (IBM)
Stock Price: $90.64
Sell Near-The-Money Put Option (Short Position): 10 contracts - June $90 @ $3.10
Buy Out-Of-The-Money Put Option (Long Position): 10 contracts - June $85 @ $1.50
Put Options Expiration Date: November (Third Friday of the month)

This position is considered a net credit of $1.60, for spread of $5. That is the difference between the sale of the higher-strike put option (short position) and the purchase of the lower-strike put option (long position) which results in a positive cash flow of $1.60 ($3.10 - $1.50). The spread represents the difference between the short option and long option strike prices, which are $5 apart (Nov $90 put option – Nov $85 put option). So, what does all of this translate to for potential profit? Let’s assume the stock price is above the short (higher) put option strike price ($90) on the June expiration date. That would translate to a maximum profit of the credit we received or $1.60 x 10 contracts (1,000 shares) = $1,600. The percentage becomes $1.60/$5.00* = 32%. (*$5.00 as denominator because you would need to keep this amount as margin before you can execute this trade.)

Now let’s look at the maximum loss potential should the stock price go below the OTM long (lower) put option strike price on the November expiration date. Our Bull Put Spread pre-determines the maximum amount we are willing to lose. The maximum loss would be the difference in put strike prices or “Spread” minus the net credit received. In our example, this translates to $5 - $1.60 = $3.40 x 10 contracts (1,000 shares) = $3,400.

By using the Bull Put Spread strategy we have lowered our risk compared to only selling naked puts. If we sold the November $90 @ $3.10 put option naked and the stock price closes lower than $90 on November expiration date, we would have a potentially unlimited loss. This is a much more significant loss than the potentially limited loss using the Bull Put Spread strategy.

Next: Final Part - Bear Call Spread

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