We use a Bull Put Spread when we have a positive to neutral bias on a stock. As with any credit spread, we take in a credit when we enter the spread and the goal is for these options is to expire worthless. If this happens, we keep the premium that we took in at the time we entered the spread.

Let's look at our January credit spread on Google. On Monday, December 11, 2006, we sent out the following New Trade Alert.

NEW TRADE ALERT

Google Inc.

January GOOG Bull Put Spread

Sell 10 Jan. puts at 440 strike price

Buy 10 Jan. puts at 430 strike price

Total Credit $0.85 per contract

Potential Profit $850.00

In this trade, we sold 10 contracts (1 contract equals 100 shares of stock) of the January 440 puts for a credit of $3.25 per contract. To figure the total credit that you receive for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $3.25, which comes out to a total credit of $3,250.00.

If you simply entered this trade without purchasing the January 430 puts, you would leave yourself open to downside risk if the stock fell. In order to protect ourselves from an extreme downward move in the stock, we finish the spread by purchasing 10 contracts of the January 430 puts for a debit of $2.40 per contract. To figure the debit that you pay for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $2.40, coming out to a debit of $2,400.00.

When you enter both of these positions at one time, you are placing a credit spread. In this trade, you would receive the difference between the puts you sold (January 440 puts) and the puts you purchased (January 430 puts) into your account. Your broker would place that $850.00 into your account when you enter the position. As long as Google finishes above $440 at the end of trading on the third Friday in January, you keep the $850.00.

With Google trading at $483 when we enter this position, this gives us a 43-point cushion. By placing our credit that far away from the stock price, we reduce our risk dramatically. This is one of the reasons why we have such a high percentage of profitable trades.

With that large cushion between the stock price and the puts we sold, you might wonder why we purchase the 430 puts. Even though it cuts down on the premium that we collect, we feel that it's important to limit our risk in case of an extreme move against us. In this case, we have limited our loss to the amount between the puts that we sold and the puts that we bought, minus the premium that we collected.

We then subtract that difference from the premium that we collected when we entered the spread.

We then take that amount, $9.15 times the number of shares (10 contracts times 100 shares per contract) and we get a total risk of $9,150.00.

It is true that spreads in general will have a negative risk to reward ratio. However, by putting on spreads that are out of the money, we are able to have a track record of highly profitable trades month after month. Everyone has heard that nearly 80% of options expire worthless. We love that figure because as option sellers, we want both the options that we bought and sold, to expire worthless on the third Friday of each month.

One thing you will notice when you enter a spread, is that your position window will probably show the spread losing money for the first few weeks. Even if the stock has not moved against you, your broker will possibly show you as having a loss. Although your cash balance in the account will show the credit of $850.00 in your account (which will be earning you interest if you have the right broker). As the expiration date nears, this loss will turn into a profit as time decay starts to eat away at the value of the options. You may want to enter some paper trades with your broker to see how the time decay and position balances react in a credit spread.

In this trade, Google closed at $489.75 on the third Friday of January. Because this was above our strike prices of 440 and 430, all the options expired worthless. Due to this, we were able to keep the credit ($850.00) that we received when we entered the spread. This is the goal for all of our spreads.