I’ve been receiving a lot of emails about the risk-defined strategies I use, namely bull put spreads, bear call spreads and iron condors. As a result, I’m going to go over several examples this week, starting with a bullish put spread example in SPY.
As always, the first step in placing a bull put spread, or any trade, is making sure the stock we are interested in has highly liquid options. We want to use the most efficient products possible.
S&P 500 (SPY) – Bullish Put Spread Example
SPY is a highly liquid product, as a result, we can move forward with a potential bull put trade.
With SPY trading for 439.88 and near all-time highs I want to place a bull put spread with a high probability of success.
Let’s take a look at the September options chain for SPY with 46 days until expiration. Once we have an expiration cycle that we are comfortable with we can then proceed with locating 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 406 put strike with an 80.59% 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.
Once my short put strike is chosen, in this case the 406 put I then proceed to look at the other half of 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. It also tells us how much capital is required for each bull put spread. The smaller the width of the spread the less capital required. When defining your position size, a key element of risk management, knowing the overall risk or capital required per trade is essential.
For our bullish put spread example, let’s take a look at the 5-strike wide spread of 406/401.
The Trade: SPY 406/401 Bull Put Spread
Sell to open SPY September 17, 2021 406 put strike
Buy to open SPY September 17, 2021 401 strike for a total net credit of roughly $0.53 or $53 per bear call spread
- Max Return: 11.86%
- Probability of Success: 80.59%
- Total net credit: $0.53, or $53 per bull put spread
- Total risk per spread: $4.47, or $447 per bull put spread
As long as SPY stays above our 406 strike at expiration in 46 days, I have the potential to make 11.86% 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 $0.53, I want to buy it back when the price of my spread hits roughly $0.26 to $0.13.
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.
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.
Moreover, I like to take off the trade if my original credit, in this case $0.53, reaches 1x to 2x my credit. So, in this case, I would look to take off the trade if it hit $1.06 to $1.59.
I hope this bullish put spread example helps give everyone a little insight into how a bull put spread works. I will be following up with a short vid going through numerous bullish put spread examples. Stay tuned!