How to Trade Bull Put Spreads on thinkorswim®

On-screen text: Options

Narrator: When you're trading options, especially if you're a beginner, you may lean toward single options strategies like long calls or short puts because you only have to manage one option. But these strategies have some drawbacks.

Animation: A risk profile of a naked put shows limited potential gain and unlimited potential loss. A high-reading risk meter is below it. A cash-secured put risk profile also shows limited potential gain and unlimited potential loss but a stack of dollar is below it.

Narrator: With long calls you have to correctly predict short-term stock behavior, which isn't easy. Naked puts carry substantial risk, and cash-secured puts can tie up a lot of cash in your account.

These drawbacks are why some strategies combine multiple options contracts. These are called spreads, and they're popular because they allow you to define your risk and reward.

Animation: An option contract is labeled "sell" and describe as a short put with a neutral to bullish bias. Another options contract is labeled "buy" and describe as a long put with a bearish bias. They're added together to create a short put vertical spread with a neutral to bullish bias.

Narrator: There are many ways to combine options into spreads based on your goals and risk tolerance. We're going to focus on one of the most common: the bull put spread, or as we like to call it, the short put vertical. This bullish strategy is known by several different names, such as a credit put spread or short put spread, but it's a basic concept: You sell one put to potentially profit from a stock going up, but also buy another put at a different strike, which provides protection in case it doesn't. This allows you to define your risk and your reward.

I'm Education Coach Cameron May, and I've been teaching traders about options for 15 years. Combining multiple options together in one trade can seem complicated, but we're going to walk through all the ins and outs.

Animation: The screen thinkorswim Web platform appears on screen displaying a chart and a list of account positions.

Narrator: We'll break down how the short put vertical works and how to set it up on thinkorswim^® web, our browser-based trading platform. It's got a lot of the powerful options trading tools of thinkorswim desktop but in a simplified interface you can access just by going to trade.thinkorswim.com.

We'll assume you already know the basics of options trading and the greeks. If you're an absolute beginner, check out our other videos to get your bearings on options basics.

Animation: An uptrends stock chart is on screen. An arrow labeled "short put" is placed below the recent stock price. Another arrow that labeled "long put" is placed below the short put arrow.

Narrator: So: Short put verticals. This is a bullish strategy that involves simultaneously selling an out-of-the-money put and buying another put with the same expiration that's further out of the money. The short put is the driver of the trade. It benefits from time decay and when the underlying stock goes up, while the long put hedges your risk.

You'll have to pay the premium for the long put, but that part of the trade is usually cheaper than the short put, so you'll wind up with a net credit from the get-go. Keep in mind, you'll still have to pay transaction costs. The ideal outcome is for the stock to stay above the short put so both options expire out of the money.

Animation: The price on the stock chart falls below the long put.

Narrator: If things don't go your way and your short put is assigned, you can exercise the long put to deliver on your obligation to sell the underlying stock at the strike price.

Animation: The chart backs up erasing the previous selloff and then the stock falls between the short and the long puts.

Narrator: It's also possible the stock could end up between the strikes. This can be a tricky situation, and we'll walk through ways to handle it later.

But now that you're familiar with the basic mechanics of the short put vertical, why should you consider this strategy? Consider risk versus return. Let's look at the strategy's risk profile to see how this works.

Animation: A risk profile of a short put animates on screen. It has a horizontal line representing the maximum potential gain and a downward sloping line representing the maximum potential risk. An arrow labeled "break even" points at a line below the max gain line. The break even is the strike price minus the premium.

Narrator: This is the risk profile of a short put. This will be your main profit driver. In order for it to be profitable, the underlying needs to stay above the break-even point, which is the strike price minus the premium. If it drops below the strike price, you run the risk of getting assigned.

Animation: A risk profile of a long put shows line sloping up to the left title max gain. The line turns horizontal as it moves to the right. It's labeled max loss. The strike price is labeled with a dotted line that intersects where the risk profile changes from diagonal to horizontal.

Narrator: Compare that to the risk profile of a long put, your hedge. You can see the risk is defined.

Animation: The short put and long put risk profiles are overlapped and then merged creating a horizontal line on the left side, an upward sloping line in the middle, and another horizontal line at the top. The break even line cross through the middle of the diagonal portion of the risk profile.

Narrator: Put them together and you can see both the max loss and max gain are capped. This is what I mean when I call this a defined risk and reward strategy. You're basically capping your potential gains in return for defining your maximum loss.

This strategy can offer a higher probability of success than other bullish strategies like long calls because—unlike bullish single options strategies—the underlying stock can go up a lot, it can go up a little, it can go sideways, or it can even go down a little, and the trade can still be profitable.

This offers a lot of flexibility, letting you manage how much profit you're willing to trade for what probability of success you want.

There is a trade-off that comes with that higher probability of success: You limit your potential profit. If the stock rises past a certain point, the cost of the long put you're buying will start to cancel out the profit of the short put.

Animation: An uptrending stock is on screen. The last trade was about $99. An arrow labeled "short put" appears at $97. A side pane opens describing the short put with a strike price of $97 and a premium of $150 multiplied by 100 to equal $150. A long put arrow appears at $95 with a premium of 60 cents multiplied by 100 to equal $60.

Narrator: To get a sense of how these really work together, let's look at an example. Let's say you're bullish on stock XYZ, and it's currently trading at $99. You think it's going to hold steady or move up slightly, so you sell a put 40 days from expiration at the 97-strike for $1.50 premium, or $150 for the contract, and you buy another put on the same expiration further out of the money at the 95-strike for $60 per contract. With these two options combined, your net credit for the spread is $90, (or $150 – $60), minus transaction costs.

Let's say you're right, and the stock does increase slightly, up to $101 near expiration. A bullish move is the best-case scenario here. Both options would expire out of the money, leaving you with your $90 credit, minus commissions and fees. We'll talk about how to manage a trade like this a little later on.

But what if the flipside happens, and the stock moves down instead? Let's say the stock drops and is trading at $93 at expiration. If that happens, your short put is assigned, meaning you'd have to buy 100 shares of the underlying. But you bought that long put for exactly this possibility. Because you bought the long put for a lower strike price, you'll only be out the distance between the two strikes.

On-screen text: Disclosure: Carrying option positions into expiration can entail additional risks; for example, an unanticipated exercise/assignment event could occur, or an anticipated event may fail to occur.

Narrator: Let's break that down by the numbers. Your short put would cost you $9,700 to buy the 100 shares, but the 95 long put would let you sell the shares for $9,500, leaving you with a $200 loss. Remember, you sold this spread for a net credit of $90, so that would offset this a little for a total loss of $110 plus transaction costs. No matter how much the stock drops—it could drop down to $50 per share or lower—that $110 is the most you'll lose on this spread.

On-screen text: Disclosure: Max loss occurs if the price of the underlying falls below the long put.

Narrator: But what happens if the stock winds up somewhere in between your two strikes? You'll have an in-the-money short put and an out-of-the-money long put. Depending on factors like the stock price and how you decide to exit the trade, the trade could ultimately still be profitable, but it might not be. What's most important is that you're at risk of being assigned stock because of the short put.

On-screen text: Disclosure: If assigned on the short put, following expiration of the long put, the trader has all the risks of stock ownership.

Narrator: If the stock does end up between the strikes, you've got a couple choices. You could let the trade expire and get assigned 100 shares of stock. But because your goal is not to enter a stock position, you'll probably want to take some action. Consider closing both the long and short puts. While the short put is the one with assignment risk, closing the long put at the same time can lock in any remaining premium in the long put, which could help offset a loss on the short put.

Keep in mind, both of these would incur transaction costs.

Now that you're familiar with potential outcomes of a short put vertical, let's take a quick look at what forces impact the value of the options. These are price, time, and volatility.

Animation: A stock chart shows the price rising by $1. An option has a premium of $4 and a Delta of .50. As the stock rises one dollar, the options premium rising to $4.50.

Narrator: The first force is price and is measured by delta. Short put verticals are delta positive, which means premiums fall as the stock price goes up. As the option seller, you want this to expire worthless. This greek will give you a sense of how much the options contract price may change with a $1 move in the price of the underlying.

The next force is time. Theta measures the impact of time decay on short put verticals. Because the driver of this trade is a short put that you want to expire worthless, it's theta positive. Remember, the max gain for this strategy is the premium you collected when you first placed the trade.

The last force is volatility. Vega tells you how rising or falling implied volatility could impact your options trade. Short put verticals have negative vega, so, ideally, you'd like to see volatility hold steady or fall. This makes sense because your ideal outcome is for both options to lose value and expire worthless.

On-screen text: Disclosure: The paperMoney^® software application is for educational purposes only. Successful virtual trading during one-time period does not guarantee successful investing of actual funds during a later time period as market conditions change constantly.

Narrator: Now that you've got the basics, let's make some paper trades. I'll log in to thinkorswim web. Here you can see all the accounts and positions, and that I'm in paperMoney^®, which allows me to place simulated trades without risking real money. I'm going to close this sidebar to give us some more room.

Ok, so our first step is to choose an underlying asset we want to trade. For this strategy, we don't need to own the stock, but we do want to make sure it's following some entry rules.

Because this is a bullish strategy, consider highly liquid assets that are already in an uptrend. Of course, there's no guarantee that the upward trend will continue, but it could increase your probability of success. You could set up a watchlist of stocks to keep an eye on.

On-screen text: Disclosure: Technical analysis is not recommended as a sole means of investment research. Past performance does not guarantee future results.

Animation: A series of candlesticks create higher highs and higher lows. The final candle breaks above a horizontal line.

Narrator: Next, we've got to determine when to actually enter the trade. Technical analysis can help. A chart pattern like a bounce off a price floor or a break through a price ceiling could be a signal that a stock is potentially ready to make an upward move.

On-screen text: Disclosure: Specific securities used to demonstrate analysis and trading functionality were selected randomly.

Animation: The thinkorswim Web platform appears on screen and an upward sloping line is drawn on the chart from the bottom left-hand corner to the upper right-hand corner. A horizontal line is drawn connecting the stocks highs in the previous month.

Narrator: For today we'll use Expedia, symbol EXPE, as an example. Here's its six-month daily chart. You can see it's in an upward trend. Let me draw a trendline here to show what I mean. You can see there was a recent price ceiling around $145. I'll draw another trendline here, so we can see that it's broken through that ceiling.

So, we know what stock we want to trade, now we've got to choose our options contracts. To do that I'll scroll up and open the option chain. Up first is selecting an expiration. For a short put vertical, the goal is to hold it to expiration and stay out of the money. There is a trade-off at play here: We could choose an expiration that's closer, which would mean faster time decay but less premium overall. Further out could provide more premium but slower time decay. For a good balance, I'll aim for an expiration that's 15 to 50 days out. So, in this case, we'll go with the March 19 expiration, expiring in 36 days.

Animation: An arrow appears at the 145 strike labeled "higher profit". Another arrow appears at the 120 strike and is labeled Higher probability.

Narrator: Next up is choosing the strikes for our short and long puts. Again, this is a trade-off. One way you adjust the trade-off between probability and profit is how far out of the money you go with that strategy. A common mistake is staying too close to the at-the-money strike in pursuit of higher potential profit or going too far out of the money for higher probability, which significantly limits profits.

Animation: A rectangular box animates around the puts' delta column. Another box animates around the 140 strike on the put side.

Narrator: For our short put, we'll look for a delta between .30 and .40. Ideally, this strike price is at or below support levels, which could mean the stock is less likely to fall below our strike. We can see the 140-strike has .32 delta and is below support. This will give us a good shot at the option expiring out of the money while still providing a decent amount of premium. It also looks like the difference between the bid price and the ask price is less than 10% of the ask price, which suggests good liquidity. So let's plan to sell that one, so I'll click the bid price. You can see it's entered at the bottom of the screen.

Now, we need to choose the strike for our long put. This strike should be below our short put. There's another tradeoff here. The width of the spread determines how much credit we'll receive for selling it. But the wider the spread, the more risk you open yourself up to because your max loss is the distance between the strikes. One common rule is to choose a long put at least $2 below the short put. For us, the next available strike is $5 away, at $135. It's allowing us some breathing room. I'll click the ask price.

Animation: The screen moves down to the Trade section. The price of the spread moves from $1.60 to $1.62. Then the mouse clicks on the price and changed it to $1.65.

Narrator: You'll notice our order now says vertical. Let's scroll down and look at it. So, here in the order editor I can see I'm selling the March 19 140 and buying the March 19 135. Now you'll notice the price of our spread is still moving. Let's lock our required credit to a limit of 1.65. And we'll leave the time in force at day.

Now we can figure out how many spreads to trade. To do this, you need to know two things: your portfolio risk and your trade risk. Portfolio risk is the total amount of your portfolio you're willing to lose on a given trade. Consider setting aside no more than 1% of your active trading portfolio per trade. So, for simplicity, let's say I'm trading with a $100,000 portfolio. If I'm willing to lose no more than 1%, my portfolio risk would be $1,000 per trade.

Trade risk on the other hand is the amount you could lose in a given trade. For a short put vertical, the trade risk is the distance between the two strikes (think short strike minus long strike) minus the credit you received from the spread. In other words, the spread width minus the credit. For this trade that's a $5-wide spread, or $500 minus the anticipated credit of $1.65, or $165, for a trade risk of $335.

Now that we know our portfolio and trade risk, we can figure out how many spreads to sell. To do this, take your portfolio risk and divide it by your trade risk. So, our portfolio risk of a $1,000 divided by the trade risk of $335 equals just about three spreads, which I'll enter in the trade ticket.

Now that we've got our trade loaded up, let's do some quick analysis using a nifty feature on thinkorswim web. Below the order ticket you'll see a stock chart and a risk profile chart. I'll zoom in so we can get a better look. On the stock chart you can see two tabs representing my strikes, and where they fall in relation to the stock's historical price. You can also hover your mouse over either chart to get a sense of where a given underlying price would fall on the other.

In the risk profile, the curved dotted line represents how different prices would impact my profit or loss today, while the green and red boxes represent at expiration. For example, we can see our breakeven for today represented by the green dotted line is approximately $150. However, at expiration, due to the effects of time decay, it'll be about $138 and half, $138.35 to be precise, not accounting for the transaction costs. You can see the stock being anywhere above there at expiration would be profitable, though once we reach $140 both contracts expire worthless and we hit max gain. In the other direction, anywhere below $135 at expiration, both options would be in the money and I'd hit max loss.

Animation: After clicking send, a white pop-up box appears in the lower left-hand corner of the screen confirming the order was filled.

Narrator: Let's go back up and place the trade. I'll click review and confirm the details are correct. Note the transaction fee, in this case $3.90, or $0.65 per contract. Now I'll click Send. There's the confirmation saying our order's been sent. Ok, we've placed a short put vertical! But this isn't a "set it and forget it" kind of strategy. We've got to make sure we're keeping up with it. The way you manage these trades can make or break them, so we're going to walk through managing some other sample short put verticals that I've got in a paperMoney account.

Animation: The mouse clicks on the Position section in the right margin and the platform changes to the All Account Positions tab. Several open trades are listed on the tab. The mouse clicks on NVDA opening a list of contracts below the symbol.

Narrator: Let's open up Nvidia, symbol NVDA. Both of our strikes are out of the money. Our original credit was $4.09, which is our maximum gain. Our current unrealized gain is around $400, leaving us with only about $9 of remaining profit. We could let it ride and leave it open for an extra nine days, and we could lose out on some gains. Since we've already achieved 98% of our max gain, I'm going to close this trade to lock in that profit.

Animation: After creating the closing order, the order confirmation appears in the bottom right-hand corner.

Narrator: To close the position I'll click the symbol, which opens up more details. The position is already selected, so I can click Close Selected to bring up the order entry. So you can see I'm selling the long put and buying the short put for a debit of $0.08. I'm going to nudge that to $0.09 to increase my likelihood of getting filled. Now I'm going to click Review, where I can see the cost of the trade, which includes $1.30 in fees.

Ok, let's go back to our positions and take a look at another one. I've got a spread on Union Pacific, UNP, and you can see both options are in the money. This is looking like a likely max loss scenario, and the risk of early assignment on my short put is elevated. But I'll give it one more day in hopes it'll turn around and I can avoid max loss. Remember, if both options were to expire in the money, my long put would help cap the loss on the short put. In any event I'll close it tomorrow, whether we're further from max loss or closer to it, in order to salvage any remaining value before expiration.

Alright, let's look at one more sample trade to answer the question, "What happens if the stock lands between my strikes?" So, on Pepsi you can see I sold the February 12 142 put and bought the February 12 137. I've only got two days to expiration, and the stock is now just above $137, so the short put is in the money, but the long put hasn't been hit yet. We're facing a potentially tricky scenario. I haven't hit max loss yet, but I'm definitely at risk of assignment on the short put and my long put is still out of the money. So, to avoid assignment, I'm going to close the position for a loss. I'll follow the same process as my earlier trade that was a winner: click the symbol, click Close Selected. I'm going to leave it at the mid-price and review the details, which show I'm buying the vertical back at a cost of $350. At expiration it could have cost as much at $500, so I'm preventing a max loss. Note the transaction fee of $1.30. Now I'll click Send.

There you go. That's the nuts and bolts of the short put vertical. Or the bull put spread. Or the … you get the idea.

Remember, even though the approach we discussed may be higher probability and less risky than others you've seen out there, it's still risky. Make sure you practice paper trading to get a feel for how these trades can move.

Be sure to check out our coaching webcasts too. We have lots of options education that you should take advantage of because management is such a huge part of trading options.

To try out thinkorswim web, visit trade.thinkorswim.com. If you want to practice, make sure you switch to paperMoney in the top left corner to get a handle on how vertical spreads work.

You can also download the full thinkorswim software, which we've linked to in the description. We have a ton of other education on our channel, so make sure you subscribe and hit the bell to get notified when we upload new videos.

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