Bull Put Spreads: Income From Stocks Moving Higher
When most investors are bullish on a stock, they only have one tool for profiting. They simply buy the stock. While buying shares of stock can certainly be one way to profit, there are many other tools available to you as an income investor. Bull put spreads are special because they let you profit from a bullish stock, without taking nearly as much risk, and without tying up nearly as much of your capital.
Editor’s Note: This is part two of a multi-part series on credit option spreads. See also:
- Part I – Credit Option Spreads: Great Tools for Income Investors
- Part III – Bear Call Spreads: Profit From Stocks Trading Lower
- Part IV – Spread Trade Permission: A Must for Income Investors
- Part V – When Should I Close Credit Spread Trades?
Stay tuned for more articles to come!
Let’s start by talking about how bull put spreads are put together. Then we can cover what could happen with your trade. Finally, I’ll show you why this specialized income tool deserves a spot in your investment account.
The Two Parts Of Bull Put Spreads
Bull put spreads are created when you sell one put contract and buy another put contract. The combination of these two transactions gives you a chance to generate income on the spot, while strictly limiting your risk.
For our example today, let’s assume you’re bullish on Under Armour (UA) shares. You believe that the stock will likely trade higher, but you don’t want to take too much risk. You’re slightly concerned that the Olympic Games may not pay off for UA as much as investors hope.
Shares of UA closed at $41.36 on Tuesday. You’re bullish on UA and believe that shares will be trading above $40 three months from now.
For our bull put spread, we’ll be using October put contracts which expire on the third Friday in October. Thats just a bit less than three months from now.
To enter the bull put spread, we will simultaneously:
- Sell the UA October $40.00 put contract, priced at $1.95
- Buy the UA October $37.50 put contract, priced at $1.25
Notice that the strike price for the put we are selling is higher than the strike price than the put we are buying. Also, we’re receiving more cash for the put contract we sold, than we are paying for the put contract we purchased.
Between the $1.95 per share we receive and the $1.25 per share we pay, we’re clearing $0.70 per share in income. Since each contract represents 100 shares, that’s $70 deposited into our account for every unit.
We call this type of trade a “credit” spread trade because we received a credit for the two parts of this trade.
Here’s What Can Happen…
Remember, selling a put option contract is simply entering an agreement to buy shares of stock at a certain price. You don’t need to already own a put contract to sell (or to enter this agreement).
By selling the UA October $40 contract, we’re agreeing to buy shares of UA at $40. But only if UA is trading below $40 when the put contracts expire. Also, by buying the UA October $37.50 put contracts, we’re buying the right to sell shares of UA at $37.50, even if shares are trading below this level in October.
That’s important because it strictly limits how much risk we have in this trade.
Once you enter bull put spreads, there are basically three potential outcomes…
Three Potential Scenarios
1) The stock could close above your top strike price. In our example, shares of UA could close above $40. This would be the best case scenario for us. If shares are above $40, both contracts expire worthless. That means we keep the $70 per contract we received and the trade is closed.
2) The stock could close below your bottom strike price. In our example, shares of UA could close below $37.50. This would be the worst case scenario for us.
If shares are trading below $37.50, we will be required to buy shares at $40. Thats because the put contract we sold obligates us to buy shares at $40. But we also have the right to sell shares at $37.50. That’s because we bought our $37.50 put contract. So no matter how low UA trades, the only risk that we have is that we have to buy shares at $40, and sell them at $37.50.
You might think that we’re stuck with a loss of $2.50 per share (or $250). But it’s actually better than that. Since we already collected $70 per contract from entering the trade, our maximum possible loss is only $1.80 per share (or $180 per contract).
3) The stock could close between the two strike prices. In our example, UA could close between $37.50 and $40. Typically if I see that this is going to happen, I will close out one or both sides of this trade so I am not left with a position in UA because only one put contract is exercised.
Depending on where the stock closes – or what we pay to buy back our put contract – we may lose a bit less than our $1.80 maximum risk, or we may make a profit that is slightly less than our $0.70 maximum gain.
Lower Returns, But Lower Risk and Much Less Capital Required
If you’ve used my put-selling method to generate income in your account, you’re already familiar with the first part of this trade. (I’m talking about selling a put contract on a stock you would like to own).
Bull put spreads take one additional step of buying a lower strike put contract. This is sort of like buying an insurance contract on your trade. Buying the extra put contract eats into your profits a bit. But it strictly limits your risk.
There’s also another big benefit for your account.
By using bull put spreads instead of simply selling a put contract, your broker knows that your risk is capped. So instead of requiring you to set aside money to buy 100 shares of stock, you’re only required to set aside money to cover your worst case scenario.
For our example, this is the difference between setting aside $4,000 to buy 100 shares of UA, or setting aside $250 to cover the difference between buying and selling your shares. This can be a huge benefit that allows you to enter more spread trades with a smaller account size.
Now this type of trade will require a margin account. And you’ll need to watch your position and potentially close out one side if the stock is likely to close between your two strike prices.
But the benefits of this specialized trade can help you make better use of your capital, while managing your risk much more effectively.
Stay tuned tomorrow for a similar trade you can use for stocks you expect to trade lower!
And as always, I’d love to hear your question about this or any other topics we cover. Feel free to email me any time (Zach@ZachScheidt.com).