Credit Spreads - Bull Put Spread
While there are numerous ways to use credit spreads, we are going to look at the bull put credit spread in this lesson. We will be able to cover the advantages and disadvantages to using credit spreads, and will be able to transfer this knowledge to future discussions about other uses for the credit spread strategy.
Credit Spreads:
The whole basis assumption surrounding the credit spread strategy is that the investor will buy one option, while simultaneously selling another option, the net effect resulting in a credit transaction. Simply put, you buy one option on a security, and sell another option on the security at a higher price, resulting in a credit transaction at the time of the trade.
Bull Put Credit Spreads
The bull put credit spread strategy is often used by option traders on underlying securities that they have bullish sentiment on. While the best case scenario is that the underlying stock will go up in price, this is not always the case, and this is where the primary advantage to this strategy is the downside protection that you are able to build into your trade.
DOWNSIDE PROTECTION: The % that a stock is able to drop, while still leaving your trade profitable.
Credit Spread Advantages
- Immediate Income
- Limited Risk
- Short Investment Time Period
- Built in Downside Protection
Credit Spread Disadvantages
- Limited Upside
- Since strategy involves a two leg option trade, you must take commissions into consideration
Bull Put Credit Spread Example
Let's take a look at a sample trade, as this will help make this strategy a little clearer.
Trade Date: 2-9-2009
Underlying Stock: Apple Computer (AAPL)
Current Stock Price: $102.50
number of contracts = 10
Summary table showing the credit spread:
| Date | Stock | Buy | Sell | Credit | # | Risk | Return | Profit | Expiration |
| 2/9/09 | AAPL $102.50 |
April 70 PUT $0.80 |
April 75 PUT $1.30 |
$0.50 | 10 | 4,500 | 500 | 11.1% | 4/17/09 |
So, what exactly are we looking at? Basically we are looking at a stock which is currently trading at $102.50, which we are betting will not be trading under $75 on expiration date, which in our example is 4/17/09.
With this built in downside protection, we will be able to lock in our profit as long as the stock does not drop by more than 26%!! Not too bad, and allows you to set up these trades, still be wrong every now and then, and make your profits as long as the market does not make serious downside moves.
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Our target return on this position is the initial credit that we receive at the time we set up the trade, in this case $500 since we are setting up a $0.50 spread and assuming 10 contracts.
Our capital at risk is the difference in strike price, less our initial credit. So we are looking at 75-70-0.50 = $4.50. Once again, based on 10 contracts this leaves us with an amount at risk of $4,500.
We determine our target return by taking 500 / 4500 * 100 = 11.1%
What can go wrong?
The worst case scenario is that the stock moves under our sold strike price of $75. In this case, you have two different approached you can take. First you can sell your long option, and buy back your short option and make up some of your capital at risk. In most cases, this will result in a debit trade that is larger than your initial credit and you will wind up taking a loss on the trade.
Secondly, you can buy back your short option and hold onto your long call and hope that the stock moves higher and you can make some additional cash once you long option moves higher. This could work out great if the stock bounces sharply, and in some cases you can wind up making even more than your initial target return. On the other side of the coin, the stock can continue to drop, and you lose the choice of selling your long option and recouping any additional cash.
Best case scenario:
Ideally, the stock either rises, stays flat, or drops less than 28% and closes trading on expiration above your sold puts. In this case, your options will just vanish and you keep the credit that you made at the time you set up the position.
Credit Spreads in Action:
You can see this option in action in our Monthly Dose Portfolio, where we set up a series of 3 or 4 bull put credit spreads each month.