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How to Trade Bull Put Spreads
12/01/2009 12:01 am EST
In previous articles, I explained two vertical call spreads; namely, the bear call and bull call. As the reader will notice, these two are not grouped by direction, for one is bearish in nature, while the other is bullish in its outlook. Most option books out there separate the verticals according to direction, either bullish or bearish. However, that is a mere matter of preference.
As long as the option trader understands that a bearish or a bullish vertical position can be built by either calls or puts, this is all that matters. The fine difference that I use in my option trading that determines whether to use calls or puts is implied volatility, or IV. Let me elaborate on this a bit more.
If I have a bullish outlook on a certain underlying, then I can go with either a bull put (vertical put sell or credit put spread) or a bull call (vertical call buy or debit call spread). One of the easiest ways to choose between the two vertical option strategies is to simply check the pricing of the premium. Many traders, in general, spend multiple hours in the selection of a perfect entry point, yet at the end, they overpay their fill due to premium overpricing.
The main reason why the premium would be overvalued is the IV. As I have pointed out in my verticals and volatility articles, I solve the selection of the vertical strategy dilemma by simply having the IV determine the strategy. If the IV is low or in its lower range, then I go with a vertical debit spread (bullish or bearish, depending on my outlook). If, however, the IV is high or in its higher range, then I certainly should not be a buyer of options, so I would do a vertical credit spread; either a bear call or a bull put, again, depending on my current forecast for the underlying. Now let me explain in greater detail the latter one.
A bull put, just as any other vertical spread, involves buying one option first and then simultaneously selling another one on the same underlying for the same expiration month, but at a different strike price. A bull put is a credit spread, for the price paid for the long put option is less than the premium received for the short put, producing a net credit. The maximum value of the spread at expiration is equal to the difference between the strike prices. Due to the fact that IV is currently sitting at its lower range, I will not provide any current, real life examples of it, but instead, we’ll use a theoretical one.
Here is an example of a bull put. Buy one put and then sell another put with a higher strike price. The lower-strike put always costs less than the higher-strike put. If the underlying is at 39 and the trader has an outlook that is neutral to bullish, then the trader could select the below strike prices, buying the 35 put and selling the higher strike price, or 40 put.
The figure above assigns prices of premium to the two strike prices in order to point out that the maximum profit on this vertical credit put spread is $150 minus commissions. The goal of a bull put is to keep as much of that net credit of $150 as possible. Again, I am emphasizing the words, "as much as possible."
Yet, what also needs to be kept in mind is how much is at risk in this hypothetical trade. I have mentioned above that "The maximum value of a spread at the expiration is equal to the difference between the strike prices." The statement means the difference between the 40 put and the 35 put is 5 points, which in our case translates to $500 dollars, for the basic assumption is that we are dealing with a single option contract. If our max profit is $150, then our max loss is the difference between the strike prices and the credit we have taken in: $500 - $150 = $350.
There are three possible outcomes to this trade, all of which are visually displayed below.
The bad scenario would mean that the underlying dropped below the lower (bought) strike price, bestowing upon the trader the maximum loss. Hopefully, the trader should be monitoring his or her bull put position actively and see that the price is dropping. At that point, he or she should close the spread to recover whatever value is left in the spread. At no point should vertical spreads ever be placed and forgotten about!
The good outcome is when the price of the underlying goes above the sold put. The goal of a bull put is to keep as much of the net credit as possible. Again, I am emphasizing the words, "as much as possible."
The in-between outcome means that the underlying closes in between the two strike prices. In such a situation, the concern becomes how near the underlying is to the bought put. The BEP, or break-even point, is the difference between the higher put strike price and the credit received. Here, 40 put minus the credit of 1.50 equals $38.50. Hence, in our example, the underlying could even go against us a bit (in the amount of the credit received) before we actually start losing money.
In conclusion, the goal of this article was to explain the vertical credit put and emphasize the point that the selling of it should be done when the IV of the underlying is at its 52-week high, or at least in the higher range. At the time of writing this newsletter, the IVs of a majority of the underlying securities that I am trading are sitting at their lows, and therefore, selling credit spreads isn’t the most profitable solution right now. For that reason, I have provided only a theoretical example.
Have a green (profitable) trading day and know your option strategies well prior to utilizing them.
By Josip Causic of OnlineTradingAcademy.com
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