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The strategy we are going to examine today is known as the Bull put spread. You simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. The maximum gain is achieved if the stock trades at or above the highest strike price. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price. We are going to put this strategy into play on American Electric Power Co., Inc. (AEP).

Before we get into the details of this strategy, let's take a look at some of the benefits associated with writing a bull put spread.

Benefits of a Bull Put Spread

  1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
  2. The ability to profit even if the stock barely budges in price.
  3. The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put on Abbot Labs (ABT) with a strike at 65, and the stock dropped to Zero, your loss would be $6500 minus the premium you received. Now if you purchased a put with strike at $60.00, your maximum loss would be $500 minus the net premium you received.
  4. The capital requirements are significantly less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $65, you would need to have $6500 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $500. This is significantly less than the $6500 you would have to put up if you sold cash secured put on Abbot with a strike at 65.
  5. In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

Technical outlook

The stock is trading in the extremely overbought ranges and has already generated a few negative divergence signals. A negative divergence is generated when a technical indicator does not confirm the new highs. The stock could trade past $46.00 before pulling back. It is more likely to $41.00-$41.50 ranges than the $48.00-$49.00 ranges in the near future. Additionally, when the stock tests the + 2 standard deviation Bollinger bands on a repeated basis, it usually signals that the stock is ready to pull back. This is especially true, if the stock has experienced a strong run up.

The $41.00-$41.50 ranges offer a pretty strong zone of support. Unless the stock closes below $41 on a weekly basis, this zone should serve as a buffer against lower prices.

Bull Put Spread

We need to sell and purchase a put simultaneously. In this instance we are going to sell the May, 2013 42 put and purchase the May 2013, 39 puts.

The May 2013, 42 put is trading in the $1.55-$1.65 ranges. We are going to assume that the put can be sold for $1.60 or better. For each contract sold $160 will be deposited in your account. The May 2013, 39 put is trading in the $0.75-$0.85 ranges. We will assume that you can purchase this put at $.80. or better. Your total outlay for each contract will be $80, leaving you with a net credit of $80.00. Your maximum risk here is $220, and your maximum profit is $80.00 for a total return of 36.4%.

Two other good plays in this sector where a similar strategy could be put to use are Duke Energy (DUK) and Southern Company (SO). They both offer good yields of 4.7% (Duke Energy) and 4.3% (Southern Company) respectively.

A strategy to boost your potential returns

You could boost your gains by purchasing a put with less time on it, while selling one with more time on it. For example, in this case, you could purchase the Feb 2013, 40 puts at $.45 or better and sell the May 2013, 42 puts at $1.60 or better. In this scenario, your total monetary requirement would be only $85.00 ($160 from sale of put minus $45 you paid for the purchase of the second put = 115. You would then subtract this from the $200 needed to initiate this strategy, which leaves you with at total monetary requirement of just $85). Your maximum total profit is $115, which works out to a total return of $135%.

Risks associated with this strategy

The main risk is that you over leverage yourself because the capital requirements are so small. Using the example in this article, you would need $6500 to sell one cash secured put in Abbot. However, you would only need $500 to write one bull put spread. This means you could technically write up to 13 bull put spreads. Even though the risk is low of having the shares put to your account because of the long put you have in place as a hedge, there is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. Thus, the biggest risk is that an investor might abuse this strategy. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.

The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Thus, it's would be wise to close the short option out before your position hits the maximum loss point. Professionals generally take this route when the short option at or slightly in the money. In this instance you have some leeway as your breakeven point would be $41.20.

Conclusion

The long-term outlook for this stock is bullish as it is still in a strong up trend. The stock is overbought but should find support in the $41.00-$41.50 ranges. A pullback to these levels will probably be temporary in a nature. Every decline of $3 to $5 in the past two years has proven to be a buying opportunity. This strategy provides you with the potential to lock in sizeable gains without having to tie up too much capital. Do not abuse this strategy as there is a chance the shares could be assigned to your account if the stock trades below the strike price you sold the puts at. You can always turn around at sell the shares if they are assigned to your account, but you will need to have the money in place to cover the cost of buying these shares before you can sell them. If you over leverage yourself, you could be asking for trouble. One way to minimize your loss would be to close the position out if the stock is trading slightly below the strike price. Your breakeven point in this case would be $41.20. After closing the position out, you could write a new bull put spread. Utilized properly this strategy can produce a steady stream of income.

Options tables sourced from yahoofinance.com. Option profit loss tables sourced from Yahoofinance.com

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware

Source: American Electric Power: A Potential 36% Return With This Low-Risk Strategy