Tuesday, April 6, 2010

Bull Put Spread - Part I

When the market is bullish, one of the most popular spread trades is a Bull Put Spread.  This is a combination trade where the trader buys a put and sells a put creating a spread trade (combination of two or more options) that creates the following risk graph from MachTrader:

The Bull Put Spread is a credit trade.  When the position is entered, a credit is received into the account.  The credit is the Maximum Reward that can be obtained on the trade.  If the trade remains in the traders “favor” and the position goes to expiration, then the entire credit remains in the traders account.  Depending on the final outcome, a partial amount of the credit may be left or a debit may occur in the account if the position has gone against the trader.

Here are some general guidelines in setting up this trade:
1.    Look for a Bullish Stock
2.    Set the trade so that both strike prices are below the price of the stock.
3.    Buy the lower strike price Put and sell the higher strike price put.
4.    Have the Strike Prices next to each other (i.e., the 210 and 220)
5.    Expiration should be no more than 2 months out.
6.    Try to realize a minimum net credit of 10% or more of the spread.
7.    On the Short Put (the Put that is sold), have a Delta that is equal to or less than 0.20.  This represents an 80% probability that the short option will be Out of the Money at expiration.
8.    Place the OTM strikes of the Bull Put Spread Below support.

In placing your entry order, the trader may want to consider using a contingent order that is triggered on the price of the stock.  For example, if the price of the stock goes up 10% of the ATR, then have the spread order placed.  This confirms the direction of the stock (bullish).

In the next post we will discuss how to maintain and exit the position.