The goal of selling a bull put credit spread or vertical put
spread is to have the stock finish ABOVE the put you sold at
options expiration.
Simply stated, you want the stock to stay above the short
strike until it reaches expiration. I typically sell
out-of-the-money puts, so that I have some room for error if my
assumption is incorrect.
Let me give you a simple example using a trade from the
past.
I placed an options trade using the highly liquid iShares
Silver Trust (
SLV
) as my underlying ETF. I prefer to use various ETFs to make this
trade but you need to make sure that the ETFs are liquid, i.e.
frequently traded, options on the stock in question. With silver
trading at new lows I decided to place the following trade: Sell
to open Aug11 SLV 28 puts Buy to open Aug11 SLV 26 puts
This spread created a total credit of $0.24 for a return of 12
percent if SLV closes above $28 at August options expiration. At
the time silver was trading for roughly $33. While I was bullish
on silver, I still wanted some downside protection, which is why
I sold the Aug11 SLV 28/26 vertical put spread. Again, this is
how I typically trade bull put credit spreads. I like to sell
out-of-the-money puts, in this case the SLV 28 puts to give me
some room for error. The SLV credit spread allowed for a 15
percent decline in the underlying (in this case SLV) before the
trade was in jeopardy of becoming a loser. Again, as long as SLV
closed above $28 at August expiration, I would make 12 percent on
the trade. Amazing, right? Nice upside, with limited downside.
This is why options and more importantly credit spreads are a
necessity in any portfolio. If used correctly, they can be a
powerful tool to enhance returns in your overall portfolio - even
if the market slips significantly lower.
With July options expiration behind us and August expiration
32 days away, the credit spread that I placed was only worth
$0.03. Remember, we sold a vertical put spread for $0.24, so if
we want to take the trade off the table we would need to buy it
back, in this case for $0.03. So we made the difference between
the price or $0.21. Given the limited upside remaining, I decided
to take all risk off the table and buy back the spread.
Here is the trade I placed to do this: Buy to close Aug11 SLV
28 puts Sell to close Aug11 SLV 26 puts for $0.03
Some of you might be asking why would we not just let the
spread expire worthless, which would allow us to reap the entire
$0.24?
The answer is that upside from here is very limited. While I
did not think SLV would move 28 percent lower over the next 32
days, I was not willing to take a chance on silver breaking to
new lows just to make an additional $0.03. Trading, particularly
options trading, is about taking profits when it makes sense; and
being prudent, staying disciplined and most importantly, looking
at the long-term picture.
Trying to squeeze $0.03 out of a trade (which amounts to $3
per contract) just isn't worth the risk. The trade was
successful, making 11 percent in just over three weeks. It was
time to move on to the next opportunity. While I adore my
High-Probability strategy, my favorite options strategy is the
vertical bull and bear credit spread. Essentially, the strategy
allows you make money even if a security goes nowhere. Most
securities tend to stay in a price channel over short term
periods, so using this strategy lets you make a high-probability
investment that nothing extremely bad or good will happen to the
underlying investment over the short term.
Kindest,
Kindest,
Andy Crowder
Editor and Chief Options Strategist
Options Advantage