How to Sell a Bull Put Spread

Implied volatility has remained predominantly low for well over a year now, except for a few spikes higher up when the market has sold off or there has been some pending news that can affect the market. The Federal Reserve is expected to raise interest rates this coming week, so it is doubtful IV levels will change much based on the outlook. Undoubtedly, there will be another time when the market drops and IV rises again to high levels.

Implied volatility by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market and decreases during a bullish market as we have seen. The reasoning is that a bearish market is riskier than a bullish market. With the possibility of the market falling some, there is a chance that IV may rise even for a brief time. It is a general trading principle that high IV is a signal to sell credit spreads and low IV is a signal to buy debit spreads.

Selling bull put spreads during a period of high IV can be a wise strategy, as options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average IV. Plus, the higher the credit is, the lower the risk. In addition, if the IV becomes lower over the life of the spread, the spread’s premium will also decrease based on its vega. Vega measures the option’s sensitivity to changes in the volatility of the underlying asset.

Here is an example of selling a bull put spread during a time of high IV. In this make-believe environment, IV is high across the board because the market has been bearish and there is some concern that the economy is contracting again. Despite all this, let’s say a trader is fairly bullish on XYZ stock. The trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example. To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90 in this example, and the 50 strike is at 0.90. The net premium received, therefore, is 1.00 (1.90 - 0.90), which is the maximum profit potential. Using these price points, maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 - 1.00), which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 - $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. Plus, if the IV becomes lower before expiration, the spread will also decrease based on the option vega, which could reduce the spread’s premium faster than if the IV stayed the same or rose.

When examining possible option plays and IV is at a level higher than normal, traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is that it can profit from either a neutral or bullish move in the stock.

John Kmiecik, Market Taker Mentoring

Trader Education