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Thursday, February 9, 2012

The marvelous Bull Put Spread (Wall Street)

Well I do believe I've finally fallen in love with a strategy that serves my immediate purposes. I do not have a large fund, and it takes money to make money, you might have heard? But this seems a sure and steady income as long as we're in a bull market.

First of all, we ARE in a bull market, so a bull put spread is certainly "trading the trend."

A Bull Put is a credit spread--and that means that you SELL a Put at a higher strike price, and BUY a Put at a lower strike price. The difference in the premium of these two option contracts is a credit, (income, not expense!) thus money comes straight into your account. Itis an income strategy.

So say Apple is at $486. (and this morning, it happens to be.)

I SELL a Put at the $460 Strike price for $1.55 (per contract)
Then I BUY a Put at the $455 Strike price for $1.04 (per contract)

This puts the difference ($1.55 minus $1.04) of $.51 (times 100 shares) $51.00 (times number of contracts =3) $153.00 directly into my fund.

These are weekly options, so I have 7 days until expiration. If the stock price
does NOT drop down to my short strike of $460, both options expire worthless and I keep the $153.00.

My maximum gain is $153. The maximum loss is the Difference between the Strike prices ($460 minus $455 = $5 x 100 = $500 per contract) less the credit received. So in the above example, My maximum loss is $500 x 3 contracts minus $153. That equals $1,347.00. If I divide my gain by my maximum loss, I would have a return of 11.35% if the trade is successful. Annualized it would be 591.82%!

The probability of this trade being successful (as computed by probability software in both Options Express and Trade Monster) is 84.78% Apple would have to drop from $486 to $460 in 7 days. Is it possible? Of course. Is it probable? Not so much.

Okay, so why do I like this trade? First of all, I am doing both an Apple trade and a Chipotle Mexican Grill trade every week. Looking to make $300 to $500 per week. That is what I need to supplement my income. This strategy is (so far) providing that income.

Secondly, in a credit trade, the broker "holds" a certain amount of cash as a guarantee against losses. That amount is the difference in the strike prices of the short put and long put. So in the above trade, 3 contracts x $500 is the amount the broker holds. $1500. is on hold, but it is my money until I lose it. So for me, with successful trades, this works as a safe place for my cash, since I would rather have more cash on hand than have it all invested at once in options. And as the cash grows, I can afford to trade more contracts.

And finally, it is simple and understandable. If you want to be risky, you get closer to the stock price. If you want to be conservative, you sell further away from the stock price (and make less premium).

If you have ample cash on hand (which I don't) you can play VERY conservatively, and just buy more contracts further OTM to increase the premium. Each contract means the broker will hold another $500 as insurance against loss.

Happy trading!~



  1. Hi Beverly,

    Not sure if I'm calculating this correctly, but:

    The expected win or loss for x should be E(x) = .8478(153) - .1522(1347) = -75.31134
    where x is the amount we expect to win/lose over the long run.

    This means that if we keep making this bet for a long time, over the long run we will lose $75

    What do you think?



  2. But then 1347 is the worst possible outcome, so I guess the expected outcome is better than -75. :-)

  3. I'm not sure either, Sherlock. I don't compute options this way, not a mathematician. I use the probability tables on Think or Swim, and stay one or two standard deviations out of the money, and I win more times (about 70%) than I lose. Which is how I believe the game should be played. Perhaps the example I gave in this early 2012 post (before I was thoroughly educated in the probability strategies of Tasty Trade.com) would support your math. I have no idea? But thanks for sleuthing!!!