A Simple Option Strategy

Why Would You Invest Using Options?

Options are a right to buy or sell a security at a specific price and date. Options give you great control over your risk, and the strategy you use. Lastly, options provide you a way to hedge your investments and take advantage of volatile markets.

A Simple Option Strategy If You Believe A Stock Will Rise:

If you believe the value of a stock will rise then you have two options: a bull put (vertical put sell or credit put spread) or a bull call (vertical call buy or debit call spread). Check the price of the premium in order to determine which of the strategies to utilize; this will help you avoid over-premium pricing.

Implied volatility (VIX) is the main determinant of a high premium. Therefore, you should let the implied volatility determine which strategy you should use. Choose a vertical debit spread (bullish or bearish, depending on my outlook) if the implied volatility is low. In contrast, if there is currently a high implied volatility then you should not be a buyer of options, but you should rather implement a vertical credit spread, which includes either a bear call or a bull put.

So how do you implement a vertical credit spread if there is high implied volatility?

Bull Put


A bull put requires you to buy one option first and then simultaneously selling another one at a different strike price on the same underlying for the same expiration month. A bull put is a credit spread in which the price paid for the long put option is less than the premium received for the short put, which in the end produces a net credit. At expiration, the maximum value of the spread is equal to the difference between both strike prices.

Here is an example of a bull put where you are buying one put and then selling another put with a higher strike price (lower-strike put always costs less than the higher-strike price). If the underlying is at 39 and the trader has an outlook that is neutral to bullish, then the trader could select the below strike prices, buying the 35 put and selling the higher strike price, or 40 put.

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In the example above prices are assigned premiums to the two strike prices in order to point out that the maximum profit on this vertical credit put spread is $150 excluding commissions. The goal of a bull put is to maximize the amount of net credit.

Risk, as always, must be considered in this investment. Since the maximum value of a spread at the expiration is equal to the difference between the strike prices, then the max loss is equal to to strike price differences minus the credit. In the above example the value of the strike price differences is $500, and the max credit is $150, then our the max loss is $350.

This trade has three possible outcomes:

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In the worst case scenario the underlying stock price would drop below the lower (bought) strike price, and you would suffer the max loss. However, to help avoid this you should be monitoring your bull put position actively and observe that the price is dropping. When you see that the price is dropping you should close the spread which will allow you to recover whatever value is left in the spread.

This trade is on the positive side when the price of the underlying goes above the sold put. Again the goal is to keep as much of the net credit as possible.If the underlying closes in between the two strike prices, then you will receive a profit "in-between" zero and the maximum. In such a situation, you should be concerned about how near the underlying price is to the bought put. The break-even point is the difference between the higher put strike price and the credit received.

In conclusion, you should understand how to use the credit put, and remember that the selling of the credit put should only be done when the implied volatility of the underlying is high (use moving averages or the 52-week high), or at least in the higher range. Also, you should implement a debit spread when implied volatility is low.