| Strategy in brief: Buy put option with a lower strike and sell another put with a higher strike producing a net credit.
When to use this strategy: you expect the stock to go up, or at least you believe it is a bit more likely to rise than to fall.
Comments:
- Both options should have the same expiration date.
- This is a good position if you want to be in the stock but are unsure of bullish expectations.
- This is the most popular bullish strategy, along with the “Bull Call Spread”.
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Figure: Bull Put Strategy Example
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Profit: potential is limited, reaching its maximum if the stock ends at or above the higher strike at
expiration.
Loss: limited because you buy a protective put. Loss reaches its maximum if the stock at expiration is at or below the lower strike. This maximum is equal to the difference between strikes minus initial
credit.
Risk: Limited.
Reward: Limited.
Time value decay: If the stock is midway between the strikes, there is no time effect. When the stock price is close to higher strike, profits increase at the fastest rate. When the stock price is close to lower strike, losses increase at a maximum rate.
Research Findings and Trading Tips:
· A spread with short near-the-money put contains more time value and is more preferable. For example, you establish a put option spread by buying one contract of IBM October 110 Put and simultaneously selling one contract of IBM October 115 Put. The credit is $2.15 or $215 for one contract. The maximum profit (net credit) for this bull spread is $215, and you already got it. Nevertheless, if the stock moves down, your loss is limited by the difference between the strike prices minus net credit received.
Profit/loss ratio is 0.78 = $215/$275. Is it reasonable? This ratio for a more bullish spread in our example is 1.44. The degree of reasonableness depends on how bullish you are on the stock. If the stock is unlikely to go up, neither high credit nor high profit/loss ratio would look attractive. On the contrary, if you are very bullish on the stock, a certain risk level appears quite acceptable.
Collateral requirement for options spread is usually equal to $2000 for one contract. You have to keep that much equity on your margin account to establish a spread.
With this strategy you have a unique possibility to participate in the upward stock price movements with a little investment. Additionally, you get a downside protection. Just compare to outright purchase of a stock - no downside protection and no leverage!
· If the stock goes substantially up, it is reasonable to roll the spread up (to buy back the short put at a lower price and to sell another one at a higher price). If the underlying stock drops, you can also undertake a protective action: buy back your short put at a loss and sell another one at a lower strike. It is better to sell the at-the-money put which contains more time value. Remember that the price of the protective put you bought goes up. Therefore, rolling your spread down you can reduce your losses even more.
© "Worry-free Option Trading System" & Stock Markets Institute, 2002 | 
