The goal of selling a bull put 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 (NYSE: 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.
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