Abbott Laboratories' (NYSE:ABT) share price has taken a beating recently, and historically strong pullbacks have generally proven to make for good long term entry points. However, one should always hedge oneself just in case the situation takes a turn for the worse, and that is where the bull put spread comes into play. 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.
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 Merck & Co. Inc. (NYSE:MRK) with a strike at 45, and the stock dropped to zero, your loss would be $4500 minus the premium you received. Now if you purchased a put with strike at $40.00, your maximum loss would be $500 minus the net premium you received. The difference is rather significant.
- The capital requirements are considerably 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 $45, you would need to have $4500 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 $4500 you would have to put up if you sold the cash secured put on Merck with a strike at 65. This strategy should not be abused just because the capital requirements are significantly less. This is a conservative strategy, and by abusing it, you will have converted into a speculative strategy.
- 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.
The purple lines in the above chart clearly illustrate that every time the stock has pulled back strongly, it has proven to be a good long term buying opportunity. The stock has a pretty good level of support in the $60-6$63 ranges. A test of this zone should lead to higher prices. Additionally, the stock has historically rallied every time it has tested the -2 standard deviation Bollinger bands (indicated by the yellow boxes in the above charts). It is currently trading below this band so it should be ready to trend higher relatively soon. Consider waiting for the stock to test the $62-$63.00 ranges at least before putting this strategy into play.
Abbot Labs will be compared against its competitors using several key rations such as quarterly revenue growth, P/E, EBITDA, operating margin, PEG, etc. If you feel that competitor would make for a better investment, you could utilize a similar strategy.
M= Million B= Billion
Charts of value
The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long term entry point. The stock is currently trading well below this line. Hence the current setup could make for a good long term entry point. According to Fast Graphs, it has an estimated earnings growth rate of 8.00%.
When a stock is trading above the EPS and EPS consensus estimate line, it is a bullish phase, and the outlook is for higher prices. The stock has just managed to trade above the EPS consensus line.
Bull Put Spread
Both parts of this transaction need to be implemented simultaneously.
The May 2013, 60 put is trading in the $1.78-$1.81 ranges. If the stock pulls back to the stated ranges the put should trade in the $2.20$2.40 ranges. We will assume that the put can be sold at $2.30 or better.
The May 2013, 55 puts are trading in the $0.83-$0.88 ranges. If the stock pulls back to the stated ranges the put should trade in the $1.00-$1.20 ranges. We will assume that this put can be purchased at $1.10 or better. After the transaction is complete, you will have a net credit of $120.00. Your maximum risk is $380, and your maximum profit is $120.00 for a possible return of 31%.
Strategy to boost your returns
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 (lower strike) 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 $4500 to sell one cash secured put in Merck. However, you would only need $500 to write one bull put spread. This means you could technically write up to 9 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's 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 Abbot Labs is $58.50.
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. You could always turn around and sell the shares or put the shares to the seller of the lower priced put you purchased, but you would need to have the money in place to cover the first part of the transaction. This is a conservative strategy, and if you abuse it, you will have converted it from a conservative strategy to a speculative one.
Options tables and competitors data sourced from yahoofinance.com. Option profit loss graph sourced from poweropt.com. EPS chart sourced from zacks.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.