“Buy low, sell high.” This simple piece of advice sums up the goal of every investor — to sell securities at a higher price than what was originally paid.
Of course, this is easier said than done. Buying and selling the right stocks at the right time is tricky business, even for investment pros who spend all of their time researching stocks to know when is the right time to buy and sell.
Options are one tool used by active investors to provide more flexibility when it comes to the timing of stock buys and sells, thus helping reduce some of the uncertainty and risk involved. One type of option that is increasing in popularity is the bull put spread option. This option is most commonly used when an investor expects a moderate rise in the price of a stock over the short term.
How A Bull Put Spread Works
To execute a bull put spread, you would buy one put option (a long put) while selling another put option (a short put) at the same time at a higher strike price. As a result, you are hedging your position in the stock, which limits your risk exposure by capping your potential loss. Of course, your potential gain is also capped, which is why a bull put spread is generally considered a defensive strategy.
Your objective is for the stock to rise above both put options so that they are “out of the money.” In other words, the strike price would be below the current market price and both options would expire worthless. In this case, you would keep the credit you receive when establishing the position as your profit.
An example helps illustrate how a bull put spread might work: Let’s say you have been following the stock of ABC Corporation. It is currently trading at $33 per share and you think it is going to rise modestly over the next couple of months to $35.
You could initiate a bull put spread at strike prices of $30 and $32 by purchasing a long put on November 24 for $2.60 and selling a short put on November 26 for a limit price of $3.50. Each put covers 100 shares, so you would receive a premium of $90 ($350 – $260). This $90 premium is your maximum potential profit on the bull put spread.
If the stock stays above the $32 strike price on or before the expiration of the bull put spread, both the long and short puts remain out of the money and expire worthless and you have earned $90. However, if the stock drops below $32 before the bull put spread expires, you are looking at a losing trade — it is just a matter of how much you will lose.
If the stock drops below $30 and the option becomes in the money on or before the bull put spread’s expiration date, both your long and short puts could rise in value, which is the opposite of what you were envisioning. Whether or not you decide to cut your losses by placing orders to close out your short and long puts before they expire depends on your level of risk tolerance — and if you think there is a chance the stock could still rise in price before the expiration date.
A Sophisticated Options Tool
A bull put spread is a sophisticated investing tool primarily used by options traders. You should investigate the potential risks and rewards of bull put spreads carefully by speaking with an options expert or two before trying this strategy yourself.