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Friday September 03, 2010 |
Advanced Strategies for Options -
Vertical Spreads - Bull Put Spread
The
bull spread with puts is very similar to the bull spread using
calls in that the investor still buys one option and sells another
option with a higher strike price for the same underlying
security. The
difference is the investors uses puts rather than calls. Let's return to our example.
George
is still modestly bullish for Dupont. With the common stock trading at $85 he places the
following order. He
buys 1 contract of the Dupont December 85 put at a cost of $1.50
per contract and simultaneously sells one Dupont December 90 put
for net proceeds of $5.50 per contract. This transaction creates a net credit of $4.00 per contract
or $400. Now let's
run through the results of this spread at option expiration.
|
Dupont
Share Price at Expiration
|
Profit
for December 85 puts
|
Profit
for December 90 puts
|
Total
Profit
|
|
75
|
$850
|
($950)
|
($100)
|
|
80
|
$350
|
($450)
|
($100)
|
|
85
|
($150)
|
$50
|
($100)
|
|
86
|
($150)
|
$150
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0
|
|
90
|
($150)
|
$550
|
$400
|
|
95
|
($150)
|
$550
|
$400
|
|
100
|
($150)
|
$550
|
$400
|
As
we can see, George's' strategy using puts works very well unless
the common stock falls to $85 or lower, the lower strike price in
this spread. We can
also see that George breaks even if the common stock ends at $86,
the differences between the two strike prices in the spread less
the credit received. Finally,
George gets his maximum profit if the stock rises to $90, the
higher strike price.
For
the sake of simplicity we have used conservative bull spread
strategies but the bull spread can be modified to make it very
conservative or extremely aggressive.
Conservative
bull spreads are those where both the long and short positions are
in-the-money. This
strategy is deemed conservative because the odds are greatest that
the position will achieve its maxim profit potential with the least
amount of risk (remember, the maxim profit potential is achieved
when the underlying common stock reaches or exceeds the strike
price of the short contract). Because both the long and short options are in-the-money,
profit potential will be small for this position.
A
more aggressive bull spread strategy involves positioning the
spread around the underlying common stock price. For example, an aggressive bull spread using calls would
see the investor go long the at-the-money call option and sell a
call option well out-of-the money. Because the maxim profit is achieved when the common stock
reaches the higher strike price this strategy offers greater
reward but risk is also higher.
The
most aggressive bull spread strategy involves spreading two
out-of-the-money calls. In
this strategy the cost of the spread is very small and a large
move in the stock price will produce a huge return but the odds of
large moves are often remote. If the stock advances modestly, or worse, not at all the
entire investment may be loss.
Bull
Spread Review
Bulls
spreads may be implemented using either puts or calls and it is
considered to be a strategy best used if the investor is
moderately bullish for the underlying common stock. The strategy offers both limited risk and limited reward.
Risk and reward is determined by the strike prices selected. Generally, out-of-the-money bull spreads offer greater
reward but much more risk.
For Bull Spreads Using Puts
1. The transaction creates a credit because the short put
option with a higher strike price will always be more expensive
than the long put option with a lower price.
2. The maximum loss is limited to the difference between the
two strike prices less the net credit received.
3. The break-even point for the spread is the higher strike
price less the net credit.
4. The maximum profit is limited to the net credit received.
bull
call spread 
bear call spread
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Vertical
Spreads > Bull Put Spread
