How to use a Bull Put Spread

There are, however, a number of disadvantages.  In the event of a fall in the stock price, the writer of a sold put will be forced to buy the stock at the strike price, irrespective of the price the stock falls to.  Also, sold puts are difficult to cover quickly, unlike a sold call where the stock can be purchased.  Lastly, the market tends to fall faster than it rises, making sold puts inherently more dangerous. 

The key, therefore, is to adopt a strategy which limits the risk to the writer of a put option.  Indeed, such a strategy could be considered prudent given current market conditions.

One way that the writer’s risk can be lowered is by using a Bull Put Spread. 

How is this done?

A Bull Put Spread is implemented by selling a put at a higher price, and buying a put at a lower price.  As the name implies, it is a bullish strategy, but one that offers some protection.

A Bull Put Spread should be used when the writer is bullish on a stock but wishes to insure against a substantial fall or ‘correction’ on the horizon by limiting their downside.  One stock which could be considered to have an appropriate risk profile for a Bull Put Spread is Insurance Australia Group Limited (IAG)

Insurance for an insurer

By way of background, SHAW Stockbroking has a price target for IAG of $7.25. This price target is substantially higher than IAG’s current trading level.  Also by way of background, insurance companies tend to be susceptible to major catastrophic events such as storms, floods and terrorist attacks. 

Given this profile, a Bull Put Spread strategy might well be appropriate for such a stock. 

Bull Put Spread Example

In the following example, the IAG price is correct as at 27 July 2007 and the options prices are theoretical. The example does not take account of brokerage or fees.

The first leg of the strategy is implemented by selling an IAGN1 Dec07 575 Put at 31c = +$310.  The second leg of the strategy is to buy an IAGG2 Dec07 525 Put at 10c = -$100

This position has created a net credit of +$210, which can be banked.  The net credit in this instance is the money received from selling out-of-the-money (OTM) put option minus the money paid for buying out-of-the-money (OTM) put option.

For this strategy, the maximum potential profit which the writer can receive is the net credit.  The maximum potential loss, on the other hand, is the put option spread minus the net credit received.  The following scenarios show how this would work in practice.

Scenario 1

Say the price of IAG rises to $6.50 in December. Both puts will expire worthless as the stock is above the $5.75 level.  A net credit of $210 is received.

This could have been the full $310 if the out-of-the-money put had not been bought. However, insurance costs money, which ultimately detracts from the maximum profit that can be achieved.

Scenario 2

Imagine a massive flood in greater Sydney.  The value of IAG falls 30%.  This may seem like a massive reduction however, QBE for instance fell 50% after 11 September.  This would see the stock trading at $4.04 in December.

The sold put would be $1.71 in the money and it would be exercised.  This is where the insurance in the form of the bought put comes into play.  The writer of the sold put would now exercise the bought put, selling the stock for $5.25. 

The loss would be $500 on the differential in the price between the bought and the sold put, however this loss would be partially offset by the net credit received for the sold put.  The net loss would therefore be $500 – $210 = $290.

Had you not bought the put protection, you would be forced to purchase the stock at $1.71 over its current market value, as a result of the exercise of the put, for a total loss of $1,710.  This loss would be even larger if the stock fell further.  This second scenario shows the value of the insurance.

With this strategy you still receive a credit, but you also have protection against the kind of large fall set out in the example.  The strategy also has the benefit of involving a lower margin, due to the margin offset. 

The Bull Put Spread could be used in other sectors or in respect of other events.  For instance, the recent run in NCM (Newcrest Mining) could provide a similar opportunity.

For more information about this strategy contact: SHAW Stockbroking Ltd on (02) 9238-1238 or e-mail the author:  ewalker@shawstock.com.au

Disclaimer:  This article was authored by Edward Walker of SHAW.  It is designed to pique interest in respect of a particular options strategy, rather than to provide a full explanation of the strategy or a full report on the Company referred to (the "Company").  To get SHAW's recommendations, along with any disclosures relevant to the Company, you should contact SHAW on 1800 636 625 and ask to speak to an advisor.  
This article contains general advice only.  No consideration has been give to the reader's personal circumstances.  You should contact your financial advisor in order to determine if the advice is appropriate for you.    
SHAW will charge commission in relation to client transactions in financial products and SHAW client advisors will receive a share of that commission.  SHAW, its subsidiaries, its associates and their respective officers and employees may have earned previously, or may in the future earn, fees and commission from dealing in the Company's financial products. 

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