Bull Put Spreads – an alternate strategy going into the New Year.
Since we are all concerned about where the market will be going after the first of the year, a bull put spread is a way you can participate if the market continues an upward trend, but without the cash outlay or risk level of purchasing the stocks outright. Here’s how it works:
Strategy: sell the higher strike put, and buy the lower strike put; Goal: Stock price stays above high strike put or at least above the high strike put less the net premium received; Risk: the difference between the high strike put and the low strike put, less the net premium received; Uses: when you are uncertain about the stock, expect it to go up, but aren’t willing to buy it outright, and want to hedge risk.
XYZ (this is an example of an actual transaction placed 12/29/10, with actual values and ticker changed)
Sold 10 February $38 Puts @ $2.56 = $2,560 Received
Bought 10 February $35 Puts @ $1.36 = $1,360 Paid
Net Premium Received = $1,200.00 or $1.20 per share
Max Risk: $38 - $35 - $1.20 = $1.80 per share or $1,800.00
Best Scenario: Stock closes above $38 at expiration and we keep the premium
Moderate Scenario: Stock closes at or above $36.80 at expiration… we own it, but we’re at or above breakeven.
Worst Scenario: Stock closes below $35 at expiration and we were required to purchase it and put it as one transaction, and our max loss is $1,800.
Comparative Analysis: Purchasing stock outright and placing a worst case 7.20% downside stop would cost you $38,000 in cash. Upside is unlimited, downside is $2,736. More cash outlay and more cash risk, but higher reward. However, option premiums erode over time and as they erode our gain goes up over time provided the stoke stays above our breakeven.
Give us a call if you have questions regarding this strategy or any others you may be assessing, and we can work with you to come up with a strategy that may be right for your portfolio.
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