Bull Put Spread
This should always be considered a short-term bullish trade strategy. Spread Traders will be looking to place these trades between 30-45 days prior to expiration. Just like the first strategy, the Bear Call Spread, traders are the seller of the front month options. The only difference is they will be selling put options instead of call options. Traders want to give the buyer as little time as possible to be right on the trade. That’s the beauty of this type of credit spread trading. They collect a nice income from speculators who are hoping the price will reverse and go lower. It’s their job to find stocks that have a slim chance of doing that in the next 30-45 days. The goal is to have the stock price close above the option strike price that they sold it for.
Spread traders will be using this type of spread when they are bullish (optimistic that the uptrend will continue) to neutral on a particular stock that has options to trade. Under no circumstances should a trader ever place this trade when they are bearish on a stock. It’s called a credit spread because traders will be bringing a credit into their account by selling the most expensive option closest to the stock price, and buying the option directly below it. Traders purchase the the lower strike price to hedge their position and limit their downside risk. It’s just the opposite of the Bear Call Spread.
Let’s look at another hypothetical example:
You have identified that ABC Stock is in strong uptrend (making higher highs and higher lows), and it has just bounced off major support and is beginning to head higher fast. Being a decisive trader, you check the news to make sure nothing negative has happened that could possibly reverse trend. Time to get into the game! The stock price is currently trading at $100.00. Here is how this trade will play out.
- Ticker: ABC
- Current Price: $100.00
- Buy 1 – 90 put option for $.90
- Sell 1 – 95 put option for $1.95
- Net Credit (Maximum Profit) is $1.05
- Maximum Risk $3.95
- ROI is Credit / Risk or $1.05 / $3.95 = 27%
What is the goal of this trade? To bring cash in (a credit), and keep it! You now want the stock to continue its uptrend and close above the 95 put option on expiration day (for monthly options it’s the 3rd Friday of every month). If that happens you do nothing and keep the credit you brought in. Life is good, and Credit Spreads are sweet!
Your risk decreases (and so does your credit) if you sell further away from the current stock price. If you sold the 90 instead of the 95 you may only have a credit of say .55 or a ROI of 12% on this trade. Individual traders must decide for themselves how much risk they are willing to take.
Of course there is a little more to it than that. The previous example was intended to get your feet wet with the idea of how a bull put spread works.
Benefits of Bull Put Spreads:
Higher probability of success. When traders sell options that are out of the money (OTM), they can benefit on the time decay of the option. 99% of the time they will be selling options with no intrinsic value, only time value. With a Bull Put Spread traders are able to profit in three different market movements unlike the buyer of the option who only profits if the stock moves in the direction they choose.
Monthly Cash Flow. As I’ve mentioned before, savvy traders can use their trading account to supplement their income. And now that traders can trade credit spreads using weekly options… supplementing their income is even easier. When traders place a credit spread the cash comes into their account the day they sell the option. Credit spread traders get paid upfront.
Low Risk. Traders know exactly how much you have at risk before they place the trade. They figure your risk by taking the spread amount between the strike price they sold and the one they bought, and minus the credit. In the above example there was a risk of $3.95. They bought the 90 put option and sold the 95 put option, which is a difference of 5. They then minus the credit of $1.05, which gives them their risk of $3.95.