The next level up in options strategies after the straight purchase of puts or calls is to combine different contracts into a spread trade. The name of a spread often hints at how it would be used. A bull put spread uses put options to profit from a rising stock price.
Bull Put Spread
A bull spread involves buying put options on a stock at one strike price and selling the same number of put contracts with a higher strike price. Typically, the current share price of the underlying stocks is between the two strike prices. Since the sold puts will have the higher price, the spread will be established at a credit to your brokerage account. The bull put strategy hits its maximum profit potential if the underlying stock rises above the higher put strike price.
Reasons to Use the Spread
Traders choose a bull put spread over the a bull call spread with similar potential because the spread is a credit instead of a debit to the trading account. The lower cost of a bull spread compared to just buying calls means that the spread will turn profitable with a smaller increase in the underlying share price. Use a bull put spread if you think a stock will move above the selected upper strike price -- but not a lot further by the time the options reach the expiration date.
Profit and Loss Potential
The maximum profit on a bull put spread is the credit received when the trade is initiated. For example, you think EOG Resources -- currently at $112 -- will go to $120 in the next few months. Your bull put spread sells the $120 strike put for $11.70 and buys the 110 strike put for $7.15. The price of an option is 100 times the price, so you get a credit of $11.70 minus $7.15 times 100 or $455 in your account. The maximum loss of the difference in strike prices minus the credit received happens if EOG reaches expiration below the low strike price of $110. The loss would be $1,000 -- $10 times 100 -- minus the $455 or $545.
Managing the Spread
The options trading system of your online brokerage account will let you enter the bull put spread as a single trade, filling both legs at the same time. The spread trade screen will show the range of potential credit based on the bid and ask prices of each put option leg. It often works best to place a limit order with a price between the two extremes, shading toward the higher credit amount. Once the trade is in place, be ready to close the trade early for a profit if the stock zooms above the high strike prices, or limit your losses by closing the positions if the stock moves to the low strike price.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.