One of the great things about options is their flexibility.
When buying shares, you can only make money if the market rises.
But you can profitably trade options regardless of which direction the market moves.
A “bull put spread” is a great way to profit if you think a stock or index will trade sideways or rally.
But don’t get put off by the strange name…
It simply means that we are bullish and the strategy uses put options.
And because it is a “spread,” we are buying and selling put options simultaneously.
So let’s check out an example to see how it works…
A Two-Part Trade
The Energy Select Sector SPDR Fund (XLE) is an ETF that invests in oil and gas majors like Exxon Mobil (XOM) and Chevron (CVX). And in the bottom half of the chart below, you’ll see our momentum indicator, the relative strength index (RSI).
Energy Select Sector SPDR Fund (XLE)
Source: e-Signal
You can see the RSI converging with the XLE stock price (red lines).
Based on that, we think that XLE is likely to build a base around these levels and even potentially rally.
So if you believed that XLE’s current level was going to continue to hold, you could write (sell) a put option at level “1” (upper orange line) at $81.
(Please note this is an example and not a trade recommendation.)
By writing the put option, we collect premium – our income.
But with that comes an obligation. If XLE is trading below $81 on the day of the option’s expiry, we have to cover the difference between XLE’s closing price and our $81 strike price.
If XLE fell heavily, that could mean steep losses – even after accounting for the premium we collected.
That’s where the second leg of the trade (lower orange line at “2”) fits into our strategy…
Take another look:
Energy Select Sector SPDR Fund (XLE)
Source: e-Signal
This second leg is a put option we buy with the same expiration date. And it protects us if the market falls by putting a cap on any potential losses.
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How It Plays Out
In our example, we might receive $5 for writing the put option at $81. Then we might pay $2 for buying a protective put option at $79.
That makes our maximum profit $3. (Remember, each options contract represents 100 shares, so this equates to $300 per contract.)
By buying the lower strike put option, we do give up some of our profits. But its “insurance” protects us from large losses ifour trade analysis is wrong.
And if we’re right and the market stays flat or rises, then we get to keep the rest of our collected premium ($300 per contract).
That’s why this strategy is a useful way to generate income out of the market.
In The S&P Trader, we’ve used these kinds of strategies to earn $11,456 per contract traded (if you traded two contracts, for example, it would be $22,912) since the beginning of the year.
If you’d like to learn more, I’d encourage you to check out a presentation on how it all works. You can watch right here.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict