When you sell a put, you assume the responsibility of buying a stock at the strike price of the option contract. The risk you take is that the stock drops substantially prior to option expiration and you are forced to pay much more for the stock than it is currently worth.

For example, let’s say that you sold a put on Goldcorp (GG) stock on May 29, 2009 for $1.65 per share. You get to keep that premium while assuming the responsibility of buying that stock from the holder of the put for $40 per share. By the time of June option expiration, GG was trading under $35 per share and actually closed at $34.22. That means that you were forced to buy GG at $40 while it was only worth $34.22. Your net purchase price ended up being $40 minus the $1.65 premium or $38.35. So, now your loss is over 10%. What if GG had declined further and was trading at $30 per share? Your loss would have been rather large. Is there a way to protect yourself in this scenario?

There is a way to protect yourself from substantial loss when selling puts, and you can even determine the amount you are willing to risk prior to entering the trade. You do this by creating a spread. Let’s use GG to illustrate the point. As of this writing, GG is trading at $35.64. You want to sell the July 35 put to collect some income on cash in your account and would like to purchase GG under $35 per share. However, if it drops below $30 per share, you are not at all interested. Looking at the option prices, you can sell the July 35 put for $1.35 and buy for yourself the July 30 put for $0.20 per share.

The net result is that you can collect $1.15 per share while you wait for the price to decline somewhat. If the stock drops to $34 or $33, that is OK. You will take the stock. But if the stock drops to $25, you can exercise your July 30 put so you only have that $5 difference in strike prices at risk. If you are looking to purchase 1000 shares and sell 10 put contracts, then you are risking $5000 of your overall capital. Furthermore, because of your net credit, your risk really only amounted to $3.85 per share. Granted that is more than 10% but you could have bought the $32.50 strike or even a $34 strike if that suits your risk tolerance better. Even with the $30 strike, if you end up with the stock somewhere between $30 and $35, you can then turn around and sell a covered call the next month.

This type of spread is categorized as a credit spread.  That is because you receive a credit to your account since the premium of the option you sold is more than the premium of the option you purchased.  Because you stand to profit directly from the spread if the stock increases in price, it is a bull spread.  Finally, since you are using puts, it is known as a bull put spread.  Bull put spreads can be used to generate extra income against cash in your portfolio while you wait for an overpriced stock to return to a price that you deem acceptable.