Following recent correspondence with one of our members regarding the methodology behind adjusting bull put spreads, we thought we might use today’s relative calm in the markets to talk strategy; specifically bull put strategy adjustments!
Bull put spreads are popular among option traders because they can profit in multiple directions and use time-decay to great effect. Out-of-the-money bull put spreads can profit when stocks are flat, rise higher and even pull back slightly. But what about sharp declines? With the overall markets in a bearish funk, many out-of-the-money bull put spreads placed recently may now be in jeopardy of turning into in-the-money bull put spreads. And holding an in-the-money bull put spread means risking short put assignment!
As we mentioned previously, we refused to buy into the Dow breakout chatter around the 13,000 mark and have maintained healthy cash reserves during this most recent decline. With cash on hand and many stocks dropping to very attractive valuation levels, we still don’t wish to ‘catch any falling knives’ by purchasing stocks outright, but we are becoming increasingly vigilant in scanning for stocks that we would be happy owning at these or lower levels. And the bull put strategy can assist us in realizing those objectives.
Once a stock has been found and a bull put entered, the goal is for the bull put to expire worthless. But if the stock drops below the short put strike price, is it absolutely necessary to purchase the stock via assignment of the short put?
Not necessarily! Alternative adjustments exist which are perhaps more attractive and enable us to realize a number of objectives. And what are those objectives? Well, when taking assignment of a fundamentally solid stock, the expectation is that short-term weakness will be replaced by long-term strength over time. So, even if a short-term bull put runs into trouble, the conversion to a long-term stock position can lead to fabulous profits when direction and sentiment change – as they inevitably do, even if it doesn’t feel like it sometimes!
For those who are not attracted to the possibility of owning stock and incurring the associated capital obligations, lower risk alternatives are possible! Let’s use the New York Stock Exchange Euronext (NYX) to highlight one possibility.
We’ll consider a bull put example using ‘easy’ figures to demonstrate the alternative adjustment. First, we will consider a July $50/$55 bull put spread on NYX was initiated at some point in the past. Further, we will assume that it is believed the stock has long-term appreciation potential in spite of the negative short-term sentiment.
And we will assume the following positions comprised a bull put spread that had been opened in the recent past.
Sold to open July $55 short put (credit $2.00)
Bought to open July $50 long put (debit $1.00)
Overall net credit = $1.00 per share.
Overall maximum risk = $4.00 per share
As of today’s close, NYX finished down $1.45 to $50.66 per share. So, the bull put spread is almost completely in-the-money. As expiration approaches for July, extrinsic value on the short option diminishes due to time-decay. As a result, the risk of assignment increases.
With the stock down, most traders would panic and take a loss by closing the bull put spread. This would constitute buying to close the July 55 short put for $5.10 and selling to close the July 50 long put for $1.84, resulting in a cost of $3.26. Because $1.00 of credit was received at trade entry and it costs $3.26 to close out the bull put spread, a loss of $2.26 results.
But if it is believed the stock will rebound eventually, the bull put spread can be rolled out further in time. If the short option has more time value, its assignment risk is generally considered to diminish. Let’s consider the August 55 short put, which offers $6 of credit and the August 50 long put that costs $3.25. The net credit for the August bull put spread would be $2.75.
By rolling the July bull put spread to the August bull put spread, a tradeoff occurs. The advantage of the roll is that assignment risk decreases and hence the obligation to commit increased capital to the trade diminishes. For traders who would be unwilling to commit capital, it means taking a short-term loss is replaced by committing to a longer-term trade. Instead of requiring the stock to rise up to the strike 55 level by July’s expiration in order for the July bull put to expire worthless, the stock now has an extra month in which it can rebound higher. The disadvantage is that the net result of closing the July bull put and rolling to the August bull put is the Net Credit diminishes to $0.49 and hence the risk increases to $4.51.
But what if you wanted to increase the return and reduce the risk compared to the August bull put spread shown. Is that possible? Certainly! Instead of choosing strike prices at 55 and 50 for the short put and long put respectively, strike prices at 60 and 55 could be chosen for the same options.
By selling to open the August strike 60 short put, a credit of $9.90 could be generated. And by buying to open the August strike 55 long put, a cost of $6.15 would be incurred. The net credit overall would be $3.75.
So, rolling from the losing July bull put spread to the August bull put spread would mean taking in a net credit of $1.49 while incurring a risk of $3.51. Again advantages and disadvantages exists. The advantages are obvious; the risk is reduced and the reward is increased. The sacrifice for the more attractive reward to risk ratio is the requirement placed on the stock to rise higher. As opposed to the 55/50 bull put spread expiring worthless when the stock sits above $55 per share, the stock must now rise above $60 per share before the 60/55 bull put spread expires worthless.
Does any catalyst exist for the stock to rise above $60 per share? One possibility is the company’s August earnings report. If the stock does rise higher, the bull put spread could potentially expire worthless, thereby producing a greater gain than had the original July bull put spread expired worthless. And if the stock were to drop substantially lower, a reduced loss would be incurred than had the July bull put been simply closed for a loss!
Keeping winning options open that also minimize risk is a key to long-term success. Make sure you are practising winning strategies too! It’s our mission to teach such winning methods at Stock and Option Trades!
Make it a great Tuesday!!
The Stock & Option Trades Team
