The bull put spread is a useful tool for producing income. A bull put spread is a credit spread created by selling a put while simultaneously purchasing a put with the same expiration date at a lower strike price, farther out-of-the-money, on the same stock.
This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. While the profit on this strategy can increase by as much as 1 point for each 1 point increase in the price of the underlying, the total investment is far less than that required to buy the stock. This strategy has both limited profit potential and limited downside risk, as illustrated by the risk graph below.
You would enter a bull put spread only if you feel confident the stock price will end at or above the strike price of the short put. You want to derive income from that opinion, and are willing to take a limited risk that you may be incorrect. A big advantage of the credit spread over selling naked puts is the lower margin requirement. With the bull put spread you only need to put up the difference in strike prices less the credit received.
In the example above, the stock is currently trading at $50. You could sell a January 50 put for $5.00, and buy the January 45 put for $3.00, resulting in a net $2.00 premium ($200 total) credited to your account. You need to maintain $500 (the difference between the strikes) in margin to cover the risk of this position, so you would only need an additional $300 of capital to do this trade.
By comparison, you would need to put up roughly $1,000 (or more, depending on your broker's requirements) to sell a naked put at the 50 strike price in January. That's a big difference!
The maximum profit for the bull put spread occurs when the price of the underlying stock is above the strike price of the short put. In the example above, that is $200. Even if the stock price falls below $50 and the option holder exercises the short put, you can always exercise your long put to cover the assignment. That means your maximum potential loss on this bull put spread is limited to $300.
The Bull Put Spread allows you to put time decay in your favor. It is a trade with limited risk and limited reward. You need to watch this trade because the risk/reward ratio is relatively unfavorable (you can lose twice as much as you can potentially gain in this example). To exit a bull put spread, you need to sell the lower strike put and buy back the higher strike put. Of course, as long as things go your way you can let the options expire worthless. In that case, you keep the full premium that you initially received.