The strategy we are going to examine today is known as the bull put spread. The best time to put this strategy into use is when a stock is trading in the oversold ranges, and you are still bullish on the longer term prospects of the stock. You simultaneously sell one out of the money put and purchase one put that is farther out of the money for a net credit. You purchase a put that is further out of the money to hedge your position just in case things do not work out as planned. The maximum gain is achieved if the price of 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 General Electric Company (NYSE:GE)
Benefits of a Bull Put Spread
- 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).
- The ability to profit even if the stock barely budges in price.
- 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 (NYSE: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.
- 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 a cash secured put on Abbot with a strike at 65.
- 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.
General Electric has had a very nice run-up in the past 24 months and is currently trading close to its 52-week high. The stock is definitely overbought in the short to midterm time frames. The chart above illustrates that it has a strong tendency to pull back when it has tested the +2 standard deviation Bollinger bands (illustrated by the yellow boxes in the above chart). A daily close below $21.00 should result in a test of the $19.50-$20.00 ranges. This zone should serve as a buffer against lower prices and should subsequently lead to a test of the $24.00-$25.00 ranges. Hence if this strategy is put to use, you should consider closing the position out if the stock trades in the $24.00-$25.00 ranges. As the stock is overbought our advice would be to wait until the stock pulls back to the oversold ranges ($19.50-$20.50) before putting this strategy into play.
Bull Put Spread
You need to implement both parts of this transaction simultaneously.
The March 2013, 20 put is trading in the $0.47-$0.48 ranges. If the stock pulls back to the $19.50-$20.00 ranges this put should trade in the $1.20-$1.30 ranges. We will assume that the put can be sold at $1.20 or better.
The March 2013, 18 puts are trading in the $0.22-$0.23 ranges. If the stock pulls back to the above stated ranges the put should trade in the $0.40-$0.50 ranges. We will assume that this put can be purchased for $0.50 cents or higher. After the transaction is complete, you will have a net credit of $70.00. Your maximum risk is $130, and your maximum profit is $70.00 for a possible return of 53.8%.
Two other stocks that would make for good plays to put this strategy into use are Freeport-McMoRan Copper (NYSE:FCX) and Southern Copper (NYSE:SCCO). They both sport high betas of 2.26 and 1.8 respectively. High beta stocks command higher premiums and so your total return here will also be much higher with these two plays. Both these stocks are also in the copper sector, and copper is still in a nice uptrend so the midterm outlook is bullish for these stocks. Freeport and Southern are both consolidating now and are building up momentum to trade past $44 and $39.00 respectively. Thus, it would be a good time while the stocks are currently consolidating to put this strategy into play. After the stocks take off the put premiums will drop, and investors can consider closing out the position when both stocks trade close to the above suggested targets.
Boost your returns with this strategy
One method of boosting your gains would be to purchase a put with less time on it, while selling one with more time on it. The risk of this strategy is that while you boost your gains as a result of having to put up less money, you also raise your risk. Your position will only be hedged for a limited time. Once the put you purchased with less time on it expires, you will effectively be selling a naked put and your margin requirements could rise unless you purchase another put. If you opt for this strategy, then you should consider either buying a new put or closing the position out when the put you originally purchased expires.
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. 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 would be wise to close the short option out or roll the option before your position hits the maximum loss point. You roll the option by buying back the put you sold and selling a new out of the money put. Your breakeven point with General Electric is $19.30.
General Electric is in a strong uptrend and the overall outlook is still bullish. It is overbought and could trade down to the $19.50-$20.00 ranges before trending higher. However, a test of these ranges should lead to much higher prices. The stock could easily be trading in the $24-$25 ranges over the next few months and possibly as high as $29.00 before topping out. Investors should consider closing the position out if the stock trades in the $24.00-$25.00 ranges. The options should be worth practically nothing at that time point in time, and trying to squeeze a few extra pennies at that stage would not make any sense.
The biggest and most dangerous mistake an investor can make is to abuse this strategy. There is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put does not prevent this from taking place. If the shares are put to your account, you could be in big trouble if you over leveraged yourself. While you could turn around and sell the shares, you would need to have the money to cover the cost of purchasing these shares before you could sell them.
This is a conservative strategy, and if you abuse it, then the whole purpose of putting into play is lost. You will have converted it from a conservative strategy to a speculative one. If you have over leveraged yourself 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 $19.30. After closing the position out, you could write a new bull put spread.
Options tables sourced from yahoofinance.com. Option profit loss tables sourced from poweropt.com.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.