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December 29, 2008

# BULL PUT SPREAD - FIXED

HAVING TROUBLE PRINTING?

Hi Gang,

In last night's column I made a few math mistakes in the section describing the bull put spread. So, I have fixed them all (hopefully) and the updated version is below.

Take care,

Mike

____________________________________

A Bull Put Spread is not a mystery. The words "bull" and "put" and "spread" tell the story. It is a "bullish" position. The word "put" means that puts (not calls) are used and the word "spread" means that more than one option is being used.

The Bull Put Spread is a "vertical" spread and one of the two basic components of the Iron Condor. A "vertical spread" simply means that the two options comprising the spread are both puts and they have the same expiration month.

The Bull Put Spread consists of the sale of one put option and the purchase of an option at a lower strike price. The put option that is sold will bring in more money than the put option that is purchased - resulting in a net credit. It is thereby considered a "credit" spread. The net credit shows up in our account the very same business day.

There is a maintenance requirement on credit spreads. Your brokerage firm will hold, in your account, the difference between the strike prices multiplied by the number of contracts you're trading. For instance, if you sell the \$45 put and buy the \$40 put, the broker would hold \$500 (\$5.00 x 100 shares) per contract. A 10 contract position would require \$5,000 of maintenance. The numbers, in the example below, do not include the expense of commissions.

For example: You have a short term bullish feeling about XYZ Company that is trading at \$50.00 with about four weeks remaining to expiration. You believe that, during this option cycle, XYZ is going to remain at \$50 or possibly move up in value. Below is an abbreviated option chain of the available options.

Sept. \$40 put .10 .15
Sept. \$42.50 put .25 .30
Sept. \$45 put .50 .60
Sept. \$47.50 put 1.05 1.15
Sept. \$50 put 1.95 2.05

Based on the above chain, let's explore a typical trade. Remember, we're bullish. So, let's:

Sell 10 contracts of XYZ Sept. 47.50 put @ \$1.05 (\$1,050)
Buy 10 contracts of XYZ Sept. 45.00 put @ \$.60 (\$600)
Net credit of \$450 (\$1,050 - \$600)
Maintenance = \$2,500 (\$2.50 difference between strikes x 10 contracts)

We have chosen to sell the \$47.50 put for a very good reason. It's \$2.50 below \$50 (where XYZ is currently trading). That means that XYZ can actually go down \$2.50 and we will still be 100% profitable. As much as stocks move around in a high volatility environment, that cushion is nice to have.

What is your break even number? XYZ can close as low as \$46.90 (\$47.50 - \$.60) before you start losing money.

Even though it's possible to place this trade by first buying the \$45 put and then selling the \$47.50 put, it's much better to enter the trade as a single transaction with a net credit. The problem with trading the options separately is that the market is constantly moving. If you were to buy the \$45 put for \$.60, it's very possible the market will move away in the time that it takes to learn about your fill and to send in the second order.

Most good brokerage firms will have screens that allow you to input the specifics of both options and request a net credit. It's easier, cleaner and your chance of getting filled is greatly improved.

Now, let's assume that you were right. At expiration, XYZ is somewhere above \$47.50. We calculate the potential profit by dividing the profit (\$450) by the amount of out of pocket risk (\$2,050). The out of pocket risk is the amount being held as maintenance (\$2,500) less the amount of premium taken in when the position was initiated (\$450).

\$600 divided by \$2,050 = 21.9% return on your risk. Not too shabby. But, that's if you were right. The object of the trade is for both options to expire worthless. That means you can keep the entire \$450 of premium you brought in when you established the position.

What if you're wrong? You are exposed for \$2,050. You're risk is defined and you'll never lose more than the \$2,050. But, perhaps your analysis of the trade suggests that you should exit your position if XYZ trades down to \$48. You should check the charts to find realistic support and resistance levels before placing the trade. That will give you a bit of guidance and enable you to choose an exit point where you will close the position and minimize your loss.

When you put on a bull put spread, you are not obligated to hold the position through option expiration. You can close it at any time.

You would exit the trade the same way you enter it - trading both options in a single transaction for a net debit.

If, at some point during the option cycle, XYZ moves far enough away from your bull put spread, you might be able to close the position and lock in a large percentage of the profit. If, with a week to go, XYZ is trading at \$62, the \$47.50 put may only cost you a nickel to buy it back. As soon as you buy it back, you are no longer exposed and your maintenance dollars (being held by the broker) are released back to you.

It doesn't make sense to be exposed to a possible catastrophic event for that last week for a nickel. If you held on, you would be risking the other \$.55 of premium to make that last nickel. It doesn't make sense. Take the money and run.

When we trade our Iron Condors, we put on bull put spreads on indexes rather than stocks - and we try to put them on very far away OTM (out of the money). We use indexes because they are more diversified than individual stocks. If a single stock has a problem, there are hundreds of other stocks to soften the blow. An index is not as vulnerable as an individual stock.

Our objective, when trading the indexes, is to create as large a cushion as possible. Although the bull put spread is a bullish position, we want to give ourselves a lot of room to be wrong if the market is not bullish.

Next, we'll look at the bear call spread - the evil twin of the bull put spread. The bear call spread is the other component of the Iron Condor. Stay tuned to this station . . .