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The bull put strategy is good strategy to employ if you are bullish on the outlook of a stock. It does not require much capital, your downside is limited, and you have the opportunity to lock in some hefty short-term gains. It entails the simultaneous selling of one out-of-the-money put and the purchase of one put that is farther out of the money for a net credit. Your total risk is limited to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price.

Seadrill Ltd. (SDRL) is a rather volatile stock with a beta of 1.93. It is currently consolidating, which makes it a good candidate to write a bull spread put. Higher beta stocks command higher premiums.

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 your 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 Linn Energy (LINE) with a strike at 40 and the stock dropped to zero, your loss would be $4,000 minus the premium you received. If you purchased a put with a strike at $35.00 to hedge your position, your maximum loss is lowered to $500 minus the premium you received.
  4. The capital requirements are significantly lower. 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 $40, you would need to have $4,000 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 $4,000 you would have to put up if you sold a cash-secured put on Linn Energy with a strike price at 40.
  5. In the event that the stock declines, an investor can buy to close the short put position and continue to profit from the long put as the price of the underlying stock drops.

Technical Outlook

Click to enlarge images.

Seadrill's long-term three- to five-year trend is still bullish. Over the short term, the trend has weakened and the stock is currently consolidating. It has closed below $40, a key level of support and has some support in the $38.50 ranges. However, the real zone of support comes into play in the $35.00-$35.50 range. A close below $38.50 could easily lead to a test of the $35.00-$35.50 range.

We would wait for the stock to trade below $38.00 before putting this strategy into play. A pull back to the $37.50-$38.00 range would be a good place to start at. As the support offered at the $35.00-$35.50 range is rather strong, this zone should serve as floor against lower prices. On the positive side, a weekly close above $42 should lead to a series of new highs.

Bull Put Spread Strategy for Seadrill

The April 2013 37 puts are trading in the $2.50-$2.70 range and the April 2013 33 puts are trading in the $1.20-$1.50 range. If the stock pulls back to the suggested range, the April 2013 37 puts should trade in the $3.40-$3.60 range. We will assume that these puts can be sold at $3.40 or better. The April 2013 33 puts should trade in the $1.70-$1.90 range, if the stock pulls back to the stated range. We will assume that these puts can be purchased at $1.80 or better. These two transactions need to be conducted simultaneously.

Your total monetary requirement for the transaction after the net credit is factored in (net credit is $340-$180 = $160) is $240. Your maximum risk is $240, and your maximum profit is $160, which represents a gain of 66%. Your breakeven point in this trade is $35.40. Thus, you have some leeway before your position actually starts to lose money.

Southern Copper (SCCO) and Freeport-McMoRan (FCX) are two other good plays where a similar strategy with the potential for high returns could be employed. They offer pretty good yields of 2.8% and 3.2%, respectively, and also sport good levered free cash flow rates of $1.71 billion (Southern Copper) and $2.17 billion (Freeport). Most importantly, they both have high betas so the options will command higher premiums. Southern Copper has a beta of 1.8 and Freeport has a beta of 2.26.

Boost Your Potential Returns

This can be achieved by selling a put with more time on it and purchasing a lower strike put with less time on it. In this Seadrill example, you would sell the April 2013 37 put at $3.40. You would then purchase the January 2013 35.85 put at $0.75 or better. Your total monetary requirement has now dropped to $115, but when the net credit is factored in ($340-$115 = $265), you will not have to put up any money as the net credit is much higher than the spread. Your maximum profit now stands at $255 and your potential gain surges from 66% to 176%.

However, your risk increases because after January your position will no longer be hedged. The January 2013 35.85 puts will have expired. While this approach offers a higher rate of return, it also entails more risk. You should be prepared to close the position out in January or purchase another put if you intend to hold on to the position after January.

Risks Associated With This Strategy

The main risk is that you abuse this strategy, as the capital requirements are so small. Using the Linn Energy example from earlier in this article, you would need $4,000 to sell one cash secured put in the company. However, you would only need $400 to write one bull put spread. When the net credit is factored in, you would only need $240. This means you could technically write up to 16 bull put spreads.

Even though the risk of having the shares put to your account is low (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 is trading at or slightly in the money. Seadrill would have to drop below $35.40 before you would start to lose money. If the stock drops below this level, you can purchase the short put back and sell another out-of-the-money put. Alternatively, you could close the entire position out and write a new bull spread.

Conclusion

There is still a small chance that the shares could be assigned to your account, so do not abuse this strategy. The put with the lower strike price usually serves as a hedge against assignment, but there is a chance that the shares could be assigned to your account if the stock trades below the strike price of the put you sold. If you have over leveraged yourself, you could be in real trouble. You could turn around and sell the shares if they are put to your account, but you would need to have the money in your account to cover the initial purchase.

To minimize your losses, consider closing out the position if the stock trades below your breakeven point. In this case, your breakeven point is $35.40. Alternatively, you could buy back the put you sold and sell a new out-of-the-money put.

This strategy is used to limit one's potential losses. If you abuse it, this benefit will be eliminated and you will have turned this is into a high-risk venture. Used conservatively, this strategy can provide a steady stream of income.

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: Seadrill - Limited Risk And The Possibility To Lock In An Extra 66%