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Trading Lesson: The Bull Put Spread for Stocks with Upside Bias
09/08/2017 2:53 am EST
Richard Croft, contributing editor to The Income Investor, outlines how to use the bull put spread and bear call spread. Look for more Trading Lessons each Friday from MoneyShow.com trading contributors.
As a portfolio manager who uses options to enhance cash flow for investors seeking income, it is challenging to see volatility levels at historic lows. To that point, I note that the CBOE Volatility Index (VIX) briefly traded at its lowest point in history on July 27.
The VIX is used as a gauge to measure investor complacency. What VIX does is measure the volatility implied by options on the broad-based S&P 500 Composite Index (SPX).
It does this by inputting the current price for options on SPX and then inputting those premiums into a formula that solves for volatility. Just what you want to hear in a newsletter…mathematical mumbo jumbo.
Suffice it to say that low volatility means low option premiums, which reduces the amount one gets when selling an option. Covered call strategies, which are my favorite tool for income investors, are generating below-average yields.
We find ourselves in a period where investor complacency is worrisome. Typically, we experience large moves in the underlying markets shortly after VIX reaches extreme readings. That certainly applies in the current environment, which requires experienced managers and investors to re-think their models.
In the Croft Financial Group in-house option writing pool, I have focused on limited-risk put writing strategies. That limits the risk should the market experience a correction.
Not that I think a correction is imminent, that it will be severe, or that we are headed for a bear market, but it's better to be cautious than to take on higher risk with markets at elevated levels.
The strategy that we have employed, particularly on higher-priced stocks like Alphabet Inc. (GOOG), Amazon.com (AMZN), and Apple Inc. (AAPL), is the bull put spread, which we employ on stocks that we think have an upside bias.
With both strategies (bull put spread, bear call spread), the intent is to generate cash flow for the portfolio that can be distributed monthly to unitholders.
The Bull Put Spread
Since I have opened this Pandora's box, let me explain the strategy in detail, if for no other reason than to frame its risk-reduction characteristics.
First, let me point out that with a spread strategy, we are buying and selling an option on the same underlying security. Because we are both a buyer and a seller, volatility has less of an impact. If we are selling a cheap option, we are also buying a cut-rate option, effectively muting the impact of volatility.
To cite a specific example, we sold a put option on GOOG with a strike price of $930 per share while also purchasing a GOOG put option with a $900 strike price. In this example, our risk is limited to $30 per share, which is the difference in the strike prices (i.e., $930 - $900 = $30 per share).
The sale of the GOOG 930 put option obligates us to buy GOOG shares at $930 per share. At the time of writing, GOOG was trading at $941.50 per share.
Based on the current price of GOOG, the September 930 strike put option (expires Sept. 15, 2017) was trading at $18.50 per share. The GOOG September 900 strike put, which would be the long side of the spread, was trading at $9.25 per share.
The net credit received is $9.25 per share, which is simply the difference between what we would receive from the sale of the 930 strike put and what we would pay for the 900 strike put (i.e., $18.50 credit - $9.25 debit = $9.25 per share net credit).
The purchase of the GOOG 900 strike put is our hedge. If the GOOG shares are put to us (i.e., if we were forced to buy them), it would cost us $930 per share.
However, we have the right to sell the same shares at $900. Hence $30 per share maximum risk associated with the trade. I like this approach because of its flexibility in the current environment.
I would encourage investors who are looking to generate cash flow from option strategies to consider bull put spreads as an alternative in the current environment when dealing with U.S. securities where you have a bullish bias.
An added benefit is the margin required to implement the strategy. With a spread, the margin requirement at most brokerage firms is the difference in the strike prices, which means that the margin will not change, and you will not be forced to close out a position prematurely because of an unexpected margin call.
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