If you’re looking for an alternative strategy to writing covered calls, consider a bull put credit spread.
Options are the most powerful trading tool available. Options trading on stocks may seem intimidating to many, but they are not as complicated as one might think.
This article assumes that you are familiar with the basics of options and options terminology. We will look at how a Bull Put Credit Spread is a cheap alternative strategy to writing covered calls.
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Writing covered calls is an option strategy where an investor owns at least 100 shares of a stock, and he or she “writes” (meaning “sells”) the right for someone to buy the stock from them at a predetermined price on or before a predetermined date (an “expiration” date).
For taking on this risk, the seller receives a “premium” (cash).
Let’s say you own 100 shares of stock in Shaky Savings & Loan (a fictitious bank) which you purchased at $14.45 per share, for a total of $1,445.00.
You could sell a call option for someone to buy the stock from you at a specific price. This is called writing a covered call.
The next higher strike price found on an options’ table is $15.
The option premium is currently paying $0.44 per share (actually $44, because one option contract represents 100 shares of stock).
By writing (selling) this option, you are giving the right for someone to buy your 100 shares of stock at $15 per share. For that, you receive $44 immediately into your trading account.
If the stock goes up above $15, someone will “exercise” your option, and buy the stock from you. You will receive 100 times $15, or $1,500 for selling the stock.
You’ve already made $44, so you now have a total of $1,544. Subtracting your cost from your income, your profit on the play is $99.
Downside to Writing Covered Calls
The drawback to writing covered calls is that you have to buy stock in 100 share increments, because one option contract controls 100 shares of stock.
Let’s say you would like to write a covered call on Netflix, because it is your opinion that the stock will go up over the next month.
As of this video, Netflix is going for $505.90, but you need to own 100 shares of stock just to write one option contract. Holy cow, that’s 50,590.00!
That’s way too expensive, but that’s how much you would have to spend in order to be “covered” and write a covered call.
There is a way, however, to “cover” a trade where you can make income by selling an option without owning the stock.
This strategy is known as a “Bull Put Credit Spread.” It involves selling a Put option to make income, similar to selling a Call option on a covered call trade.
To “cover” the selling of the Put option, instead of owning shares of the underlying stock, you can buy a Put option on the same stock with the same expiration date, but at a lower strike price.
Using our example, with Netflix at $505.90, the next closest strike price below the current price is $500.
Sell one Put option with an expiration date at one month out. The premium is $25.80 per share.
Now to “cover” this Put, we’ll buy a Put at a strike price below that, say $500.
The premium is $23.35 per share. So, by buying and selling Puts simultaneously, we create a Bull Put Credit Spread strategy.
We receive $25.80 in our account from selling the Put, but must pay $23.35 to buy the second Put.
Subtracting $23.35 from $25.80 we get a credit of $2.45, which is actually $245, because one contract represents 100 shares of stock.
So, just as when we write a covered call, we receive money up front in our account, but we didn’t have to buy the actual shares of stock.
If Netflix’s stock price goes up or does NOT go up over the next month, we keep the full $245.
If you own shares of the stock, and the price drops, you lose money. But with our Put Credit Spread, the stock can drop from its current $505.90 price a little, and we still make money.
In fact, if it can dropped to $497.55 we would breakeven.
Important Tips and Considerations
Wow, that sounds wonderful! We can do trades on big expensive stocks without risking big money. So, what’s the catch?
There are two things to consider. First, a Put Credit Spread limits the amount of profit you can make.
In our example, the most money we can make is the $245 credit received when we entered the trade.
If we owned shares of the stock and the price went from $505.90 to way, way up, we could potentially make much more money, as the stock increased in value.
Therefore, if we believe a stock is about to rise significantly, a Bull Put Credit Spread may not be the best strategy to use.
Perhaps buying a simple Call option would be best, as there is no upper limit as to how much profit can be made with a Call.
The second thing to consider is the risk/reward ratio. This strategy has the potential to lose a lot of money if the stock goes against us and drops significantly in price.
In our Netflix example, we could lose as much as $255. However, we should be able to avoid this if we watch our stock every day.
If the stock price drops to the breakeven point, close the trade and get out! Preservation of capital is paramount.
Bull Put Credit Spread: In Conclusion
The Bull Put Credit Spread strategy, along with three other such strategies, are clearly explained and illustrated in our book, “Trading Vertical Option Spreads On Robinhood” by Dan Keen.
Even if you are not using Robinhood.com as your online broker, you will learn how to effectively trade these strategies.
Bull Put Credit Spreads can make money if a stock goes up, a stock goes “sideways,” or even if it dips a little.
It is a strategy that even those new to learning options trading should be using often, as these spread trades have a high probability of success.
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