Generate Income With More Safety

Normally, selling put options is a good way to generate extra cash for your portfolio.

If the underlying stocks move in your favor and end up out of the money at expiration, the options just expire. If the stock moves against you, you can buy back the put to cover your position, and most times you probably would incur just a small loss. Or, if you like the stock, you can just let the stock be put to you.

But these aren’t normal times, not while the world deals with the worst pandemic in our lifetimes wreaking havoc.

Unusual Market Moves Can Hurt You

During the recent market crash, the S&P 500 fell 34% between its February 19 peak and March 23 trough. Many stocks dropped even more.

As the market was falling, many out-of-the-money March puts that looked as if they would harmlessly expire worthless suddenly jumped deep into the money. The values of put options in general went up, up, up.

Put writers who didn’t hedge saw their seemingly-sure profits suddenly turn into big losses.

That’s the risk to writing puts. Your upside is limited to the premium you receive when you sold the put no matter how high the stock goes. However, your downside could be much bigger than that, depending on how far the stock falls.

Managing Risk With a Spread

This is why experienced options traders often use multi-legged trades to hedge their positions.

One way to protect yourself is through a bull put spread.

The strategy involves writing a put as you normally would, and also buying a put with the same expiration date but lower strike price.

The cost of buying the put reduces the net premium you receive, but it protects you on the downside.

Example of a Bull Put Spread

Let’s use Snap, Inc. (NSDQ: SNAP) as an example to illustrate how a bull put spread might work.

As of this writing (May 8, 2020), SNAP is trading right around the $18 mark. You like the company and you want to buy the stock if it pulls back modestly in the next month, so you sell 3 contracts of the June 19, 2020 $18 puts for $1.27 ($381 total).

On the other hand, you don’t want the stock if it falls back more than 10% over the next month because that might mean something really bad is happening. To hedge your short put position, you buy 3 contracts of the June 19, 2020 $16 puts for $0.53 ($159 total).

You end up with a $222 credit ($381 – $159) in the trade. This is your maximum gain if you held both legs of the spread to expiration. The maximum gain occurs when SNAP ends up above $18 at expiration and both contracts simply expire worthless.

(To keep things simple, I will ignore the trading commission, which nowadays should be negligible. If it isn’t for you, find a new broker.)

What Happens if the Stock Moves Against You

On the flip side, if you held both options to expiration, your maximum loss will occur when SNAP falls below $16. This means both options would be exercised. You are obliged to buy 300 shares of SNAP at $18 but you simultaneously sell 300 shares at $16 to the counterparty. You lose $600 ($2 x 300), but you have a net credit of $222 to partially offset the loss, so your maximum loss is $378.

Put in another way, even if another crash happened and SNAP fell to $10 in the next month, you would lose no more than $378. In this scenario, if you didn’t have the hedge in place, and you let 300 shares of SNAP be put to you at $18, your position would have been immediately $2,400 underwater.

The above graph summarizes the gain and loss of this trade at different SNAP prices.

Be Fluid

Of course, the graph assumes that you hold both options to expiration. In practice, you are free to adjust your position as market conditions change. For example, if the market crashes again, and you buy to close out the $18 put but stay long the $16 put, you would likely make more than $222.

This strategy is best used when you think the stock will move up modestly and you want to earn some extra income while managing downside risk. Another advantage is that if your broker requires you to write a cash secured put (to reserve enough available cash to buy the shares if the put is assigned) you would need less money. In our example, you would only need $600 instead of $5,400. But beware that you do reduce the size of the net premium you receive.

Is the exchange worth it? You’ll have to ask yourself.

The bull put spread is just one of many strategies you can use to trade options profitably. But maybe options aren’t for you.

If you’re looking for ways to generate profits that are perhaps less complicated, turn to my colleague Nathan Slaughter.

Nathan has the ability to pinpoint investment opportunities in corporate takeovers. He has developed a proprietary screen that uncovers how Wall Street rigs certain stocks that are involved in mergers and acquisitions…so you can buy these stocks before they shoot up in price.

In fact, Nathan is ready to reveal his latest winning stock trade. Click here to join in the profits.