I have been selling a lot of naked puts this year. A lot. Taking a look at my spreadsheet I would estimate that just 2 months deep I have been in and out of 50 or so trades. If I had to guess that is a tremendous amount of trading for a retail investor (but maybe I am wrong). Since options trading is currently what I am obsessed with I have been reading and thinking about the topic at an increased rate, and the more I read the deeper the rabbit hole gets. There are a ton of strategies out there, so instead of getting overwhelmed I have decided to take one at a time and break it down on my blog. I am learning while I am writing. If I can’t explain it with some sense of clarity then I don’t understand it myself and I either need to spend more time on the topic or I should stay away from the strategy.
The first strategy that inspired this line of posts, is one, that I didn’t even know had a name. I came up with the basic idea (explained below) and then shot it off my buddy who got me into options, and he gently explained to me that I am not original and the strategy has a name.
What is the Bull Put Spread?
According to the Options Industry Council a Bull Put Spread is,
A bull put spread involves being short a put option and long another put option with the same expiration but with a lower strike. The short put generates income, whereas the long put’s main purpose is to offset assignment risk and protect the investor in case of a sharp move downward. Because of the relationship between the two strike prices, the investor will always receive a premium (credit) when initiating this position.
Wow, that is a mouthful, right? We are going to break down each part of the trade so that both you and I understand it completely at the end of the blog post.
In essence, it is a two part trade that limits your downside risk for a set amount of income known up front at the beginning. So let’s look at the two legs of the trade, individually, and then we can take an example. We are going to use Microsoft and the April 2017 options.
Looking at a Microsoft Put Option Example
The current put contracts for April 21, 2017 are quoted below:
You may need to zoom in to read better but the two you need to know for this post are:
- $60 strike price for $.32
- $55 strike price for $.08
The First Leg of a Bull Put Options Trade – Selling a Put
The first part of the trade is selling a put. When you sell a put you are,
giving the owner the right, but not the obligation, to sell a specified amount (usually 100 shares) of an underlying asset at a set price within a specified time.
So if we were to use the above quotes. I could sell the $60.00 strike price at .32 – this would provide me with $32.00 of income credited to my account (minus trading fees of course). If the contract was held to expiration there could be 3 different mutually exclusive outcomes:
- On April 21, 2017 Microsoft is above the strike price of $60 the put contract would expire worthless and I get to pocket the $32.
- On April 21, 2017 Microsoft is at the strike price of $60.00 the put contract would expire worthless and I get to pocket the $32.
- On April 21, 2017 Microsoft is below the strike price of $60 and I assigned (put) 100 shares of MSFT at $60.00 (i.e. $6,000) regardless of what Microsoft is worth.
If Microsoft is worth $30 a share then I am looking at $3,000 of book losses when I wake up and check my account! There is real risk in these strategies, and I have had to both try and roll out of unprofitable trades and have even been put stock before. I have written extensively on this part of the trade.
The Second Leg – Buying a Lower Strike Put Option
In the first leg of the trade I sold a put, and in the second leg of the trade I am buying a put with a strike price deeper out of the money. Since I am on the other side of the trade at the expiration date I am keeping the option to put 100 shares of MSFT at $55.
If I were to buy the $55.00 put it would cost me $8 (.08 x 100), and again, we would have 3 mutually exclusive possible outcomes:
- On April 21, 2017 MSFT is trading above the $55 strike price then my $8 is gone and the contract expires worthless.
- On April 21, 2017 MSFT is trading at $55 then my $8 is gone and the contract expires worthless.
- On April 21, 2017 MSFT is trading below $55 then I can put my shares to the seller of that contract regardless of what MSFT is actually trading.
An Example of a Bull Put Spread
Since we fully understand the two legs of the trade we can put the whole thing together. In our hypothetical example we are:
- Selling the April 21, 2017 MSFT put for a Credit of $32
- Buying the April 21, 2017 MSFT put for a debit of $8
The net effect in my account is a positive $24/contract, but that is less important than working out why someone would enter into this vertical spread contract. The main reason people enter into a bull put spread is to limit the downside risk that is inherent in selling naked or covered puts. If Microsoft plummets to $30 a share I, as seller of the put, have to take the 100 shares at $60! In the bull put spread I am limiting that risk. Yes, I may be put 100 shares at $60, but I can force someone to take 100 shares at $55. This means my maximum loss would be $500.
I like Options Playbook graphical representation of the Bull Put Spread (which they also refer to as the Short Put Spread):
As you can see the profit is capped but so is the loss, both possibilities are clearly defined at the beginning of the trade.
What Do I like or dislike the Bull Put Spread?
I really like this strategy. I have already came up with a few ways to reduce the risk of selling naked puts, but those methods of screening can’t guarantee anything. By employing a Bull Put Spread I think I would be able to bring down my requirements for such a large cushion between current price and strike. Currently, I like a 5 to 10% cushion between the price of the equity and the strike price, but maybe I can bring that down to 2 or 3% when I know my possible losses were capped.