What a vertical spread really is? Would you like to make some bucks two times out of three and even if the market is stuck and goes nowhere?
Vertical spreads are a popular option strategy that gives traders the chance to make a profit when the market goes sideways earning from the passage of time and using time decay in your favor.
This tutorial is a step-by-step guide on how to trade a vertical bull put credit spread, which is amongst the most traded vertical spreads.
The Vertical Bull Put Credit Spread
A vertical bull put spread is an option income strategy giving best results when carried out on a short-term period’s time. It is basically a neutral to bullish strategy, meaning that one can be profitable trading underlying that are either range bound or rising.
The main purpose of a bull put spread is to generate an income by selling option premium on a monthly basis. In fact, this option strategy is made up by buying and selling simultaneously two legs (two different kinds of options) having same expiration date, but different strikes in a way that allows traders to lock in a credit.
You receive a net credit because the puts sold will be more expensive than the puts purchased, which are further OTM. In fact, you can easily perform a bull put spread by selling OTM puts (lower strike than the underlying security) and buying further OTM puts to protect yourself in case the underlying falls.
The option purchased act as an assurance for you; if the underlying dropped sharply your maximum loss would be limited. In other words, you sell puts to receive an income and buy puts to limit your downside. To reduce your maximum risk, your maximum reward will be limited to the net credit received.
Rule of thumb: trade only options having lower strikes than the current underlying price and do your best to maximize the initial net credit by selling high priced puts and buying cheaper options premium.
Steps to follow carefully to trade a bull put spread:
Sell a strike puts lower than the stock price. E.g. If the stock is being traded at $50 in a particular day, sell the strike $49 (if the spread between different strikes is $1) or $45 (if the spread between different strikes is $5) and so on.
Buy a strike puts lower than the sold puts strike. E.g. If the stock is being traded at $50 in a particular day and you have sold strike puts at $49, you must buy the same number of a lower strike puts at $48 or $47.
Risk Involved on a Vertical Bull Put Spread
In a bull put spread the maximum risk is limited as well as the maximum reward. Purchasing puts further OTM than the ones sold; you reach the goal to cover the unlimited risk of the sold put. The price of having your risk limited is a limited reward too.
Risk Profile of a bull put spread:
Maximum (Limited) Risk: Differences between strikes - Net Credit Received
Maximum (Limited) Reward: Net Credit Received
Breakeven Point: Higher Strike (Short Put) - Net Credit Received
Return on Investment (ROI): Reward/Risk Ratio
Imagine XYZ is trading at $30 on August 17, 2021 (let's suppose spreads are $2.5). You should sell the Sept 2021 - 27.5 strike put for $1 (the option sold must be in correspondence of a strong area of support).
You should buy the September 2021 - 25 strike put for $0.5 (the option purchased should allow you to cover your downside risk and, in the meantime, give you enough net credit to make your position profitable).
Max Risk: (27.5 – 25) - 0.5 = $2
Max Reward: 1 – 0.5 = $0.5 (Net Credit)
Breakeven: 27.5 – 0.5 = $27
ROI: (2/0.5)*100 = 25%
As said, puts options purchased work as an assurance for your position limiting the downside risk. In addition, when you choose the strikes, you should be able to find an adequate cushion (around 10% - less only if you can take higher risks) below the current underlying price.
For instance, if the stock is being traded at $30, you should sell puts with strike at $27 and buy calls with strike at $25. Your breakeven point will be at around $26.7, giving you around 10% downside protection. The key is to assure a wide protection on the downside while also securing a decent yield, preferably over 10% (around $0.50 net credit for a $5.00 spread between the strikes).
In any case, the level of cushion depends on how close you are to the expiration date and the level of risk you can manage based on your experience, skills and funding availability.
Bull Put Spread and Time Decay
In a Bull put spread, your aim is to earn on a daily basis as the time go through. In order to gain an advantage from the passage of time, you should be buying and selling OTM options getting into the trade with a positive theta. In such a situation, you make a profit if the stock doesn’t move at all.
Time decay helps you when your position is profitable (both options OTM) and will start to work against you when the position becomes loss-making (both options ITM). An unprofitable bull put spread, having a negative theta, will be becoming more dangerous as it approaches the expiration date.
It is recommended to trade this strategy within 30 days or less to expiration to give yourself less time to be wrong on the decision you made about the trade direction. In fact, it is in the last month that options lose dramatically time value.