Selling a Bull Put Spread – Earn While You Snooze!

Selling a Put Spread makes money in three ways.  First, there is a time-decay component.  Unless they are deep in-the-money, the option price has a substantial time component.  When an investor buys an option, he/she is looking to profit if the price of the underlying stock, index, or ETF goes up (call) or down (put).  This movement must occur before the option expires.  So the price that is paid for the option includes this time component.  The second component of the option price is based on volatility–the market’s expectation for price movement.  The higher the volatility, the more the option costs.  The third way selling Put Spreads makes money is when the underlying ETF goes up.  Since these are directional, bullish trades, the value of the short option (the one that is sold) decreases as the price moves up.

As time marches on, and not much movement is seen in the underlying asset, the time value starts eroding.  If the ETF never gets to the strike price by the expiration date, the option expires worthless to the buyer.  The seller, however, gets to keep all of the premium that he/she was paid for the option.

When we sell a Put Spread, the put that is sold is all extrinsic (i.e. time) value.  If we are paid $2.00 by the option buyer, for example, we should be able to buy it back at a lower price after time passes, assuming that the price of the underlying ETF hasn’t moved down too much or has gone up, and assuming that volatility hasn’t increased too much.  By selling when volatility is relatively high, we can expect it to go lower over time and we benefit from this in addition to time-decay.  One of the major reasons that investors are unsuccessful selling Put Spreads is that they do not use implied volatility percentile (IVP) as a criterion for making the trade.  Trading them when IVP is too low will have a negative return in the long run.  In addition, our research (and that of others) has found that it is important to take profits when we have them and not let the trade go to expiration.

So sell your Put Spread and then take a nap, or watch your favorite sports team.  Time will do the work for you as you keep some or all of the premium you were paid.

NOTE: Not all will be winners.  In fact, there are quite a few losing trades in our back testing.  But by selling when volatility is high and following our trading rules, these trades have provided a very attractive return.

 

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