Mark Larson

Strategies > BULL PUT SPREADS

Many Traders complain that their broker won't allow them to sell naked options, or that they require tens or hundreds of thousands of dollars in the account in order to do so. Well, there is something that you can do which will allow you to participate in these types of trades without the same margin requirements. One way is to execute spreads. Simply, you sell a put, then buy a put at a lesser strike price. What that does is eliminate the risk of a total collapse. Your total risk is the difference in the strike prices, and with every broker I've ever known that is all the requirement necessary.

Let's walk through one. Now this can get complicated if this is the first time you've ever done it, so you may have to read this 2 or 3 times.

Let's use Dell Computers (DELL) as an example. A few minutes ago Dell was trading at 91 13/16.  Several strategies using options can be employed if you think Dell is going higher. Of course, you can buy calls. For the calls to make money, it has to go high enough and soon enough for your trade to be profitable. You can sell naked puts, and if the stock remains above your strike price you keep the premium. You would be at risk if the stock totally collapsed, and that's why brokers have restrictions. So to eliminate that risk, you can open a spread.

Dell's at 91 13/16.  If you think Dell will close above 90 on expiration date, you could execute a spread similar to this. Sell the Feb 90 put, and buy the Feb 85 put. This is known as a credit spread, also referred to as a bull put spread.
1.  Sell the Feb 90 Put for 4 3/8 (That's the bid price. That's all you'll get when selling) You'll collect $438 for the put that you sell. 2.  Buy the Feb 85 Put for 2 3/4 (That's the ask price. You'll have to pay ask when you buy) You'll pay $275 for this put. So your net, or credit, is calculated   $438 - $275 = $163 So you have the potential to earn $163 in this trade by selling and buying one contract. Your margin requirement is $500. That's the difference in the strike prices. That's the absolute most that you can lose on the trade. If your broker requires more than $500 to execute a 5-point spread, fire him!  Your total risk would be $500. No one should require more than that, and I'm sure they don't. Further, if your account is set up to buy options at all, you should be able to open spreads without filling out any other forms or anything else. So you can participate in selling of puts without selling naked puts.

Now, what can happen in this trade? First, if the stock goes higher or at least remains above 90 on expiration date, then both puts will expire worthless and the $163 credit you received is yours to keep. There's nothing to do, no need to call your broker or anything else. They'll just expire and the money stays in your account. How much would you have made? You would have made $163 on a $500 investment. What?!!! Yep, your broker requires $500 in your account to collect $163. Do the math --- $163 divided by $500 = 33%.  Thirty three percent for about a month's trade. Do you see how selling puts and spreads can be lucrative? Many traders prefer selling puts to writing covered calls. I do both.  Now I have left out one thing... the commissions. And yes, you will be charged 2 commissions. One for selling the put, and one for buying the other put. So you do have to consider commissions in here. If you were trading just one option, then the commissions might cut in to your profits so much that it's not worth it. But if you were selling 10 then you can see how it gets
better. You'd collect $1630 on a $5000 cash requirement in your account. Now commissions don't take such a bite.

Now the down side... Let's say the stock tumbles.... going down, drops below 90, keeps dropping, goes to 80, keeps going, drops all the way to zero. What happens? You close out the trade. The 90 Put that you sold is biting you in the butt, but the 85 is your salvation. Whatever you have to pay to buy back the 90, is offset by the 85 Put, less the 5 point spread. So your total loss can only be 5 points.

If this is all new to you, then paper trade some spreads and get the feel for it. If you trade online, the first time you execute a spread, call your broker on the phone and get him to open the trades for you. You want to make sure that you open and close both sides of the trade at the same time. Otherwise, you could get caught "naked".