A lot of investors are afraid to trade options. The reason people fear options is that one of the first rules we learn when looking into options trading is that they come with a high level of risk.
While it is true that options can be risky, if used properly, they can actually reduce the risk involved with picking a winning stock.
First, let's consider the trader who simply invests in stocks. In order to make a successful stock-only trade, they have to pick the right stock, at the right price, and then choose the perfect time to exit the trade. You have to be right with every decision you make, or you will never make any money in the market.
On the other hand, using a bull put credit spread on the same stock can not only bring in higher return that you can expect from a stock-only trade, but also allows you room for error in case the stock actually trades lower.
The way to set up a bull put credit spread is to sell a put that is at or near the money, while buying the same number of puts one or more strikes lower. The transaction results in a net credit, which serves as your profit on the trade should everything go as planned.
To understand this strategy better, let's look at a sample trade on Wal-Mart (WMT).
Wal-Mart is currently trading at $69.66. We are going to set up an April 60/65 bull put credit spread on the stock. We will be selling the 65 puts for $0.55 a contract, and at the same time buying the 60 put for $0.15, resulting in a net credit of $0.40 per contract.
To determine our potential return, we use the following formula:
Credit Received / (Sold Strike – Bought Strike – credit received) *100
So in our trade, we are looking at 0.40 / (65 – 60 – 0.40) *100 , or (0.40 / 4.60) *100 = 8.6%.
We will earn our 8.6% as long as Wal-Mart closes trading on April expiration at or above $65. Since the stock is currently trading at $69.66, this means that the stock can fall as much as 6.7% while still earning us our full 8.6%. By comparison, if we were to go with a stock-only trade, Wal-Mart stock would have to trade up to $75.65 in order to make the same return.
If, on expiration, the stock closes above the sold strike your options disappear from your account, and you are left with your initial credit.
We also need to figure out the break-even price on the trade. To determine this, we subtract the credit from the sold strike price. So in our example the break even is 65 – 0.40, or $64.60. As long as the stock closes at $64.60 or better on April expiration we have a break even trade, which is a much better alternative to the 7.2% loss we would have take on a stock-only trade if the stock fell to that level.
Of course, there is always the risk that the stock will fall below our break-even, and that is where this trade will start to cause us problems. If this occurs you will to buy back the puts you sold and sell the ones your bought. The values on the puts will rise, with the sold put rising by more than the one you bought. As a result it will cost you more to exit the trade than the credit you initially received.
Your total possible loss is the difference in strikes less your original credit.
As you can see, there are positive and negatives to using the bull put spread. On the positive side, you can build in protection, and you can earn a return much greater than you could expect to get from a stock only trade
On the negative side, when the trade goes against you there is a sizable loss that you will be forced to take, and unlike a stock-only trade you will be forced to take the loss, as opposed to being able to hold on to a losing stock in hopes that it will bounce and erase some of your losses.
Before you start trading options, make sure you do plenty of research, and fully understand all of the ins and outs of the trade before taking it live.