A Bullish, Risk-Defined, Options Strategy for Steady Income: Bull Put Spread, Step-By-Step Approach

bull-put-spread-IWM-example

A bull put spread, otherwise known as short put vertical spread, is one of my favorite risk-defined options strategies.

As the name of the strategy implies, a bull put spread is, well, a bullish-leaning strategy.

But it is important to note that the strategy doesn’t require the security to move higher to make money. With bull put spreads you not only have the ability to make a return when a security moves higher, you can also make money if the stock stays flat or even if the stock pushes slightly lower.

The first step in placing a bull put spread, or any trade, is making sure the security we are interested in is highly liquid. We always want to use the most efficient products possible. It just doesn’t make sense to have to make 5% to 15%, possibly more, to get back to breakeven.

iShares Trust Russell 2000 ETF (IWM)

IWM is a highly liquid product, as a result, we can move forward with a potential bull put trade.

With IWM trading for 226.40 and near all-time highs I want to place a bull put spread with a high probability of success.

IWM-stock-chart-june-2021

Let’s take a look at the options chain for IWM going out 28-65 days until expiration.

IWM-options-chain-july-2021

It looks like the July 23, 2021 expiration cycle with 31 days left until expiration fits the bill. As a result, let’s take a look at the put strike with approximately an 80% probability OTM (out-of-the-money), otherwise known as the probability of success on the trade.

It looks like the 212 put strike with an 80.07% probability of success is where I want to start. The short put strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.

bull-put-spread-example-IWM-july-2021

Once I’ve chosen my short put strike, in this case the 212 put I then proceed to look at a 3- strike wide, 4-strike wide and 5-strike wide bull put spread to buy.

The spread width of our bull put helps to define our risk on the trade. The smaller the width of the spread the less capital required. When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread-width and my premium increase as my chosen spread-width increases.

For example, let’s take a look at the 5-strike, 212/207bull put spread.

The Trade: IWM 212/207 Bull Put Spread

Simultaneously:

Sell to open IWM July 23, 2021 212 strike

Buy to open IWM July 23, 2021 207 strike for a total net credit of roughly $0.52 or $52 per bear call spread

  • Probability of Success: 80.07%
  • Total net credit: $0.52, or $52 per bull put spread
  • Total risk per spread: $4.48, or $448 per bull put spread
  • Max Potential Return: 11.6%

As long as IWM stays above our 212 strike at expiration in 31 days, I have the potential to make 11.6% on the trade.

In most cases, I will make slightly less, as the prudent move (and all research backs this up) is to buy back the bull put spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.52, I want to buy it back when the price of my spread hits roughly $0.26 to $0.14.

Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But, taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.

Risk Management

 Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor…it also allows you to sleep well at night.

6 comments on “A Bullish, Risk-Defined, Options Strategy for Steady Income: Bull Put Spread, Step-By-Step Approach

  1. Lewis on

    I have a question or two about expectancy or expected value and the risk -to-reward ratio in your credit spread example. It looks like you have a large risk-to-reward ratio and negative expectancy. From my calculations, 0.8(.52) – 0.2 (5-.52) = 0.416 – 0.896 = -0.48 which shows negative expectancy . The risk-to-reward ratio is 4.48/0.52 = 8.61 .
    Other options traders on the web say not to do this trade due to its negative expectancy; others say it isn’t necessary to consider expectancy. I’ve lost more times than I wish to say in my credit spread trades. So, this is confusing to me. I’ve missed something in your method as you are a careful, conservative trader. What are the best risk management steps (bail out if the stock price becomes the same as the short strike price and only risk 1% per trade) or something else? My preference is to close the trade before maximum loss if possible when the stock price is dropping. Would you provide guidelines to my dilemma?
    I like your method of teaching with the step-by-step, detailed, written instructions.

    Reply
  2. Andy Crowder on

    Lewis,

    Great question and one that I’ve been asked for several decades now. Ultimately, when trading based on probabilities it’s a matter of allowing the law of large numbers to do the heavy lifting. So, sequence risk will come into play occasionally. It’s all about building those occurrences so the expected value, in this case, the 80% probability of success, can work out. Moreover, when thinking about the vertical spread in the example, it’s not a straight 80%/20% (win/loss), right? The 20% is based on a max loss calculation and most of the time max losses do no occur, either due to the underlying strike not reaching a max los state, or because sound risk-management techniques come into play (adjusting, stop-loss). Plus, it is important to remember, the probability is actually less at the 207 strike. Either way, professionals have been using vertical spreads successfully for years. It’s a wonderful strategy. But like any strategy, it isn’t foolproof. Which is why I always teach that to be a truly successful options trader you must diversify your approach among a basket of different options strategies that take advantage of different types of market environments (bullish, bearish, neutral). I hope this helps and thanks again for the question.

    Reply
    • Tyson on

      If you are managing losers on defined risk spreads, where are you managing those? 2X credit, 3X credit, short strike going ITM, etc?

      Reply
      • Andy Crowder on

        Tyson,

        The most important part of risk management is position-size. Always, always, always use proper position-size or you will inevitably fail. Knowing that the law of large numbers are on my side…think about a casino, or insurance company…I can then look to other forms of management and that’s potential adjustments (if practical), and a disciplined stop loss plan. I tend to go with 1x to 2x my original credit for risk-defined trades. I hope this helps.

        Reply
  3. Lewis on

    Thanks for reminding me that the calculation I showed was max loss. Sound risk management must be used. Reaching into the deep recesses of my memory, it seems that I did not manage my losing credit spread trades as I was totally focused on the probabilities only. I should look at the complete trade and not just one parameter of it. Regards.

    Reply
  4. Andy Crowder on

    Tyson,

    The most important part of risk management is position-size. Always, always, always use proper position-size or you will inevitably fail. Knowing that the law of large numbers are on my side…think about a casino, or insurance company…I can then look to other forms of management and that’s potential adjustments (if practical), and a disciplined stop loss plan. I tend to go with 1x to 2x my original credit for risk-defined trades. I hope this helps.

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *