Earn High-Probability Income (And Limit Downside) With This Next-Level Strategy
Let’s say you’re comfortable with simple options trades like buying calls or selling puts. Have you thought about stepping up your game even further?
As you may know, options are not necessarily the risky derivatives the average investor might think. In fact, when used right, they can add additional layers of protection. And today, we’ll touch on one of those strategies.
Specifically, it involves what’s known as an options spread. We first touched on the basics of the option spread in this article. Option spreads can be a tremendous tool for generating high-probability income. While the trade setups may take a little more thought and planning, a spread can create reliable income while keeping risk at an acceptable level.
Today, we will explore a strategy known as a bull put spread. This is used to generate income from a stock or ETF in which you have a bullish bias. The trade benefits from time decay, adds income to your account, and limits your potential loss by taking offsetting positions.
Let’s jump in and see how this income strategy works.
Setting Up a Bull Put Spread
To initiate a bull put spread, you sell one put option while buying another on the same stock. You use the same expiration date, but one has a lower strike price than the other.
The put with the higher strike price will naturally have a higher option premium because it is closer to or already in the money. So, this trade will result in a net credit. This means you are actually paid for putting this trade on, and the payment is deposited into your account immediately.
You get to keep the premium if the stock remains above the short put’s strike price.
In a standard put-selling strategy, you know that you will be assigned shares if the stock’s price is below the put’s strike price on expiration. This can be a great way to purchase shares of a stock at a discount. The downside of the put-selling strategy is that losses can mount if the stock continues to decline. With a bull put spread, the maximum loss will be the difference between the two strikes, less the premium received for setting up the trade.
If the stock is between the two strikes at expiration, both puts will expire worthless. You would be in the same position as if you had just sold a put, buying shares at the strike price. Your cost basis would actually be lower than that as you would subtract the premium you received. From this point, you must manage your stock position and determine whether to sell, hedge, or allow it to run.
If the stock continues to decline past the long put’s strike price, you will still be assigned shares. But the long put will be in the money and offset the losses in the stock position. While this scenario would still result in a loss, that loss will never be more than the difference between the strike prices minus the premium received.
Obviously, spread trades work best when your bias is correct. But the beauty of this approach is that your maximum loss is capped, helping you protect capital while earning income for your investment account.
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