Trading Lesson: The Bull Put Spread for Stocks with Upside Bias
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.
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