How To Use Bull Put Spreads

January 26, 2013

How To

option spread - bull

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Bull Put Spread

A trader uses this strategy when they believe the price of the stock will increase in an alotted time frame. To conduct this trade you will buy one put that is “out” the money and simultaneously sell a put that is “in” the money. Remember both options must be on the SAME underlying stock with the SAME expiration date. This trade limits our risk because we are selling an “in” the money put and therefore limits our potential profit. I will explain in more detail in a moment.

  1. When you buy the “out” of the money put you are required to pay the premium upfront.
  2. When you sell the “in” the money put you will receive a premium upfront.
  3. This combination results in you receiving your maximum profit upfront.

This strategy will require you to enter the trade on a credit. In short you will receive money at the beginning of the trade, but remember this is because we sold an “in” the money put and does not guarantee you will be profitable on the trade.

Downside Risk:

Bad News: If the underlying price of the stock falls below the strike price of the put you sold “in” the money. Then your prediction did not come to fruition and you will take a loss.

Less Bad News: The loss you will incur is only difference between the two strike prices of the options you bought and sold minus the credit you received to enter the trade. That’s it! Of course we never want to lose money but when you sell the “in” the money put you significantly reduce the loss you would have incurred.

Limited Profit Potential:

Good News: If the underlying price of the stock rises above the strike price of the put you bought “out” of the money. Then your prediction and analysis was correct and you will receive a profit.

Even Better News: The profit you will receive is the full amount of the credit you received when you entered the trade.

Ok whew!! I know that was a lot and more technical than I would have liked but it was necessary. Let’s take a look at a real world example. I like showing examples because I am more of a visual learner myself!

Real World Example:

You see that MSFT is currently trading at $27.25 and you believe that by March 15, 2013 it will be trading for more than $28/share.

MSFT - Microsoft options

You decide to execute a bull put spread trade by buying the “out” of the money March $27 (strike price) Put for $82 (remember options are 100 share lots) and selling the “in” the money March $28 (strike price) Put for $141. This would bring your net credit price to $59. Not bad!

Options Schedule - MSFT

 

Outcomes:

Good: On March 15, 2013 the price of MSFT is trading above $28. Since the price is above both strike prices the options will expire worthless and you will keep the initial credit of $59 as profit you received to enter the trade.

So So: On March 15, 2013 the price of MSFT is trading between $27 & $28. Since the price is below our “in” the money put of $28 you will be required to purchase 100 shares of MSFT at $28/share. The “out” of the money put of $27 that we purchased will still have value so we would need to close both positions to recoup whatever value is left and avoid having to purchase the stock outright. This is typically known as the “break even point.”

Bad: On March 15, 2013 the price of MSFT is trading below $27. Since the difference between the strike prices are $1 you will be required to pay $100 for each contract MINUS the credit you received upon entering the trade. So in this case we would have to pay $100 – $59 for a $41 loss.

There you have it! I hope you have learned something and can add this to your trading arsenal.

Here’s to our Wealth!

Do you have experience with options spreads? If so, how were your results?

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