A lot of investors are afraid to trade options. This is partially because everything options-related carries a lengthy disclaimer explaining the high levels of risk involved.
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, but also allows you room for error in case the stock actually moves 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, so long as everything goes 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 put for $0.55 per share, and buying the 60 put for $0.15 per share, resulting in a net credit of $0.40 per share.
To determine our potential rate of 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 at above $65 per share at April expiration. 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 climb to $75.65 in order to make the same return.