Bull Put Spread

A bull put spread is a bullish strategy in which a put option is sold and a lower put option strike price is bought. It is much the same as selling a naked put with the exception that you minimize your margin requirement and you limit your downside by purchasing a lower put strike price.

Lets look at MU for an example of how this works. At a recent price of 36.50 MU looks like it might be ready to break out of a 3 month basing pattern. Overall you are bullish on the stock but would like to enter into a trade that gives you some downside protection in case you are a bit premature on your decision. A bull put spread may fit the bill. You start off the trade buy selling the Jan 35 puts at 1.94 and then buying the Jan 32.50 puts for 1.31. This would leave you with a .63 profit per share.

Now since you have sold the Jan 35 put, you are allowing someone to put the stock into your account for 35.00 per share. If on expiration Friday the stock closes above 35.00 then there is a strong chance that the buyer of the put you sold will choose not to exercise the put and will not force you to buy the stock at 35.00. In this scenario you will maintain the .63 per share (630.00 per contract) and the trade will be complete. You will not need to close out any contracts, as they will all expire.

If you were a bit early in your decision process and MU decides to drop in value you will want some downside protection. This is where the Jan 32.50 put comes in handy. Since you bought the Jan 32.50 put, you have the right to put the stock (Sell it) to someone at 32.50 per share. If MU really starts to drop and hits 30 or even 29, then you can be sure that someone will want to exercise their 35.00 put and assign MU to you at 35.00 per share. You can now take the stock that you have just bought at 35.00 and assign (sell) it at 32.50 to someone else.

The reason that these types of trades are so popular is that the trader knows before entering the trade the maximum profit and maximum risk associated with the trade. In the case of MU The stock is currently trading at 36.50 Selling the Jan 35 put for 1.94 and buying the Jan 32.50 put for 1.31 leaves you with a .63 profit per share. If the stock goes up you will make no more than .63 profit per share. If the stock does not move in price and stays at 36.50, the puts will expire worthless and the profit will be .63 per share. If the stock drops to 35.00 and the 35.00 put is not exercised against you your profit remains at .63 per share.

A loss starts to occur in the trade when MU starts to dip below you cost basis on the trade. If you entered this trade with a .63 profit per share this would make your cost basis in the stock 34.37 (35.00 - .63 = 34.37). As long as the stock closes above 34.37 you will make a profit on the trade. Your maximum loss is also calculated before entering the trade. By selling the 35 put you are allowing someone to sell you stock at 35.00. By buying the 32.50 put you are buying the right to sell the stock for 32.50. The most you can lose would be the difference between the 2 strike prices or 2.50 (35 – 32.50). Since you also brought in .63 per share when you entered the trade this now lowers your maximum loss potential to 1.87 per share (2.50 - .63). The 1.87 is also the margin needed per share to do the trade in your account. So a bull put spread on MU selling the Jan 35 puts and buying the Jan 32.50 puts on 10 contracts would tie up 1,870.00 in margin with a profit potential of 630.00. 33.6% profit potential for the next 2 weeks of trading.

Working with Bull Put Spreads and there support levels. More on this...

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