Bull Put Spread

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.

Bull Put Spread Overview

The bull put spread consists of simultaneously writing 1 out of the money put and purchasing 1 farther out of the money 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.

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)
• How much income or compensation you collect (net premium).

Insuring Stocks?

Additionally, like any self-respecting insurance company, you purchase reinsurance to protect yourself in case of a catastrophic event.

With the bull put 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 less expensive 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).

Bull Put 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 chain 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).

Bull Put Spread Scenarios

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. Your original net credit is reduced by the amount the $30 put is in the money. 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 in the money and consist fully of intrinsic value), but because you received $50 in premium at the outset, your maximum loss will be $200.

Bull Put Spread Variations

#1. It should be noted that a bull put spread is essentially a naked put that you've added protection to.

It should also be noted that the protection is of the catastrophic kind. In situations of moderate declines in the underlying stock, the naked put will actually provide more downside protection - at least at first.

For example, in the scenario we laid out above, the bull put produces a $0.50 net credit which means you don't begin losing money until the stock trades below $29.50/share. In contrast, the naked put produces a $1.00 credit, so you wouldn't begin losing money there until the stock declined below $29/share.

The big difference, of course, is that the bull put trade caps your losses and the naked put doesn't. Remember - option trading is always about trade offs.

#2. 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.

The iron condor produces maximum income/gains as long as the stock closes within the trading range determined by the two components of the trade.

Pros and Cons of the Bull Put Spread

There are both advantages and disadvantages to the bull put spread.

Advantages

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 wrote a naked put in our 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, 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, 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

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 a naked put, 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, 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.

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