Want a high-probability Option strategy that is safe and highly profitable?
Then you want to trade the Bull Put Spread (aka Short Put Spread).
The Bull Put Spread is a neutral-to-bullish Option strategy that seeks to profit if the market goes up, sideways, or even if the market goes down.
That is why the Bull Put Spread is widely used by many people who trade Options.
But although it is a high-probability strategy, the risk-to-reward ratio is usually low.
On a $5 wide Bull Put Spread, you’re usually risking around $350 to $400 just to make $100 to $150.
So if you don’t manage your risk properly and trade it the right way, you can lose money with this strategy.
So how do you trade it the right way?
The Bull Put Spread Strategy (Put Credit Spread)
The Bull Put Spread is one of the two popular Credit Spreads (the other is the Bear Call Spread).
This strategy consists of two Options:
- A Short Put (usually out-of-the-money (OTM)).
- A Long Put (further OTM).
And the distance between the two strikes is called the width of the spread.
By design, this is a defined-risk strategy.
That means the maximum risk has already been capped on entry and you can’t lose more than what you risk for the trade.
So for example, if the spread of the width is $5 and you received $1.50 in premium, your maximum risk would be $5 minus $1.50 which equals $3.50.
That would mean your maximum loss on this trade is $350 per spread (one short put and one long put).
So even if the stock goes to $0, the most you can lose is $350.
That is why this strategy is very suitable for new Option traders and those with small accounts.
Now, if you come from the traditional world of trading where you can only Long or Short stocks, you will notice that this risk-to-reward ratio is that favorable.
You’re risking $3.5 to make $1.50.
That means for every loss, you’d need to make at least three winners to be profitable.
So how are you able to be profitable in the long run?
How To Be Profitable Trading The Bull Put Spread
One of the biggest struggles that many new traders have is comprehending the math to make the Bull Put Spread profitable.
If you were to take a look at the risk profile for a Bull Put Spread that has $1.50 in credit, it would look something like this:
This risk profile shows the P&L for the Bull Put Spread if held to expiration.
You will notice that it has approximately a 66% win rate and a 34% loss rate.
Many new traders upon seeing this immediately conclude that this is a losing strategy.
That’s because they calculate the expectancy in this way:
(Win Rate x Max Profit) – (Loss Rate x Max Loss)
= (66% x $150) – (34% x $350)
= -$20
Based on this, they conclude that this is a losing strategy.
However, there are three flaws with this calculation.
Firstly, even if you hold the trade to expiration, you don’t necessarily hit the max loss all the time.
If you look at the risk profile from the $97 mark to the breakeven at $100.51, you will see that it’s possible for the stock to settle within those prices at expiration.
This means that you could lose less that the max loss at expiration.
Now, although the winning side is similar, the range is smaller from $100.51 to around $102.
This makes the chances of profiting less than the max profit at expiration slimmer.
Secondly, the win-loss percentages shown in the risk profile are the theoretical percentages.
However, the actual percentages are very much different.
That is to say, in reality, the win rate is actually higher and the loss rate is actually lower.
The table above is a study done by the TastyTrade research team.
This study shows the win rate of the Bull Put Spread over a number of years based on a 30 delta Short Put strike.
So theoretically, the win rate should be only 70% approximately.
But in reality, the win rate when help to expiration is 90%.
So if we take these percentages and make a simple calculation based on the maximum profit and loss, we will derive the expectancy as:
(90% x $150) – (10% x $350)
= $100
We now have a positive expectancy.
And even if we were to take just $1.00 in credit for the trade, we’d still be profitable:
(90% x $100) – (10% x $400)
= $50
Thirdly, if you close the trade out early at 21 days-to-expiration (DTE), you can significantly reduce the average loss.
And that will subsequently shift the expectancy calculation in your favor.
So you might be wondering why is the actual win rate higher than the theoretical loss rate.
That’s because the Implied Volatility often overstates the Realized Volatility.
I explain it all in this video:
3 Key Criteria To Further Put The Odds In Your Favor
Now, although we now know that the Bull Put Spread is profitable, we still want to be selective on when we put on the trade instead of putting it on randomly.
So here are 3 key criteria to help you further put the odds in your favor when trading the Bull Put Spread.
Key Criteria #1: Wait till the market is oversold.
At any time, the market will be in one of three market conditions:
- Overbought
- Neutral / going sideways
- Oversold
If you were to put on a bullish strategy like the Bull Put Spread, would you rather put on the trade when the market is overbought, going sideways, or oversold?
It would be when the market is oversold because then there would be a likelier chance that the market would go up then.
So to identify what condition the market is in, we use either the Stochastic Oscillator indicator or the Relative Strength Index (RSI) indicator.
Key Criteria #2: Place the Bull Put Spread below a support level.
Support areas are where the price has shown that there is some buying pressure.
That means that the market is less likely to go below these support areas compared to other areas on the chart.
That is why we want to place our Bull Put Spread below these support areas.
This way if the market trades down to the support area, there’s a chance it would bounce back up if it fails to break the support levels.
Key Criteria #3: Short leg of the Bull Put Spread is around 20 – 30 deltas.
While the definition of delta is the “theoretical estimate of how much an option’s value may change given a $1 move up or down in the underlying security”, it can also be used as a rough estimate of the Probability of Profit (POP).
For example, 30 deltas would approximately be a theoretical 70% POP, and 20 deltas would approximately be a theoretical 80% POP.
And as we already, the actual win rate will be higher than the theoretical.
However, we don’t want to go lesser than 20 deltas because we won’t get enough premium for the risk we’re taking on the spread.
Bull Put Spread Trade Example
Now, let’s put everything together with a trade example.
In the chart above, you can see that the stock has traded down to the support level at $129.03.
The stock had previously bounced off this level so there’s a likelihood that the market could bounce back up after touching this support area.
At the same time, the Stochastic Oscillator is showing an oversold reading.
With this, both criteria one & two have been met.
The next step is to choose our Bull Put Spread strikes.
Since the support area is around $129.03, we want to choose the strikes that are below this.
If you take a look at the Option chain on the right of the chart, we would choose either the 125 or 120 strike price as the short leg as they are both around 20 to 30 deltas.
If we go with the 125/120 Bull Put Spread, we would be able to get a credit of $1.37.
And if we go with the 120/115 Bull Put Spread, we would be able to get a credit of $1.03.
Both are valid choices.
And that’s how you place your Bull Put Spread!
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