I am going to assume that the reader has at least a rudimentary knowledge of options. Let's start off by saying that this is a credit spread strategy. This means that when the trade is executed and filled you will be paid. The funds from the sale are automatically credited to your account. The trade comprises the simultaneous sale of an out of the money (OOM) put option and the purchase of an OOM put option. Because this is a credit strategy we want to collect more money from our sale than we spend for our purchase. Any two options that meet these criteria can be used to create this strategy however we want to be more judicious in our selection in order to optimize our trade.
There are quite a few factors to consider when choosing which two options to pair for this trade. Because we are implementing a short bull put spread we are the seller of the spread. We are the sellers because we are getting paid immediately. Consider the two options as bound together into a single instrument.
First select a stock whose option you wish to trade then visit www.finviz.com to look up the target price that the analysts have set, and take notice of the beta value too. Equities with a beta value > 1 are more sensitive to market conditions. Values > 1.25 are very sensitive so you need to remember this when selecting which options to trade. You will need to account for the beta value when selecting tradable options. Choose a stock that is at least 20% under the target price but no more than 40% lower than its target. After selecting the equity with which to implement this strategy find a stream of current prices for your selections. Option prices fluctuate, sometimes violently, during the trading day. This is called volatility. Volatility is your friend when you are an instrument seller. Always use real time prices. Never use prices from the newspaper or even 15 minute delayed prices. Only the most current prices will do, so use your broker's real time price feed, which is usually provided free of cost anyway.
Volatility and prices are bound together because increased volatility causes exaggerated option pricing. Exaggerated volatility causes cognitive dissonance or irrationality in the collective consciousness of the option trading community. Exaggerated price swings yield significant additional premium for sellers. The increased activity level attracts more emotional traders seeking easy profits. This condition is also good for sellers because there are more anxious buyers and sellers whose behavior is temporarily less than rational willing to overpay for an option. This condition is more prevalent at certain times of the day too, roughly the first hour and last two hours of the trading day. Trading velocity tends to fade at around 11:40 ET while the institutional traders are away leaving the trading assistants to man the trading desks. This hiatus lasts a good two hours. Keeping this in mind remember that when the stock market sells off sharply or violently marks the approach of the optimal time to sell a bull put spread. When the market is in a frenzied state the implied volatility is higher than it normally is causing everything just discussed to occur. It takes courage to sell when prices are plummeting but remember that put prices increase as prices fall. The more violently prices fall the better it is for the seller.
The next question is how to tell exactly when to make the trade, i.e. when to sell. To answer this we need to do some technical analysis. To do this we must take a step back to look at the bigger picture. Bring up a chart of the underlying stock symbol. For example if you want to trade an Amazon put spread then bring up a weekly chart of AMZN to see what it has been doing over the past year. If the stock is going relentlessly down then you might want to stay away because there is no basis to predict when it will stop going down. We are looking for a stock that was sinking and has leveled off for the past few months. This is a judgment call on your part. Do the same with a daily chart for the past three months. From the daily chart you want to gain a sense of the overall direction for the past three months and how choppy the price action was. You may want to look at the daily candles in an attempt to divine the direction for the next few days, viewing the daily chart with the relative momentum index indicator can help with this task. If you see a doji then stay away until you see a bullish candle pattern such as a morning star. The reason you should look at candle patterns is because a large number of traders are also looking at the candle patterns for market direction insight. They will be selling when a bearish doji appears. When they are finished selling a bullish candle pattern will appear and traders will start to buy; at this point the stock price has probably reached its lowest price. Consequently selling the spread at this point will fetch you a good price. Candle interpretation is more art than science so it takes practice. The essential idea is that when everyone is trying to sell to close their positions it is a good time to sell to open your position.
Once you have sold your spread, you want the underlying stock price ideally to rise or to not fall lower A rising stock price will diminish the value of the options you sold so that that you could repurchase the spread for less than you sold it thus netting the difference as profit. To maximize your profit you can wait for the options to expire OOM. The main point is to make sure that both options are OOM when they expire, if not then you may be assigned upon expiration to become the possibly unhappy owner of the underlying stock. The moral is that if the stock price on expiration day is too close for comfort then buy the spread back while it is OOM. You will still gain the lion’s share of the profit while forgoing the anxiety of the last trading hour on expiration day. If however you are assigned you can simply sell the stock when the time is right to recoup your funds or even make a profit.
At this point we have determined the day on which to make the trade. Because we are selling we want to sell at a time when the implied volatility is higher than usual and there is lots of trading action. As noted previously the start of the trading day and the end of the trading day is generally the best time. This is a personal preference item so I will say here what my preferences are. I use ThinkOrSwim charts and I set up two different customized charting intervals of 1600 and 333 ticks. Stocks usually trade very quickly so use 1600 ticks otherwise use 333 ticks. In this charting mode you can see the number of ticks change on the chart as live trades are made. If the number is changing rapidly there is a lot of trading activity. As for chart indicators I like Bollinger bands set at one standard deviation. As the ticks roll by you can see a rising stock ride the upper Bollinger band on the way up perhaps occasionally falling to the middle of the band before bouncing up again. If the stock falls below the middle of the Bollinger band there is a good chance that it will fall to the lower band. Other indicators I use are the MACD to show me the directional tendency of the price stream. I also use the Ease of Movement indicator and the Demand Index. These two indicators are very sensitive and should both be headed up along with the MACD when you make the trade. Before you pull the trigger on the trade though , take a glance at the news feed (or on finviz) to make sure there no breaking news items such as analyst downgrades (poison), federal reserve announcements, or negative news in general that will tank the whole market. Positive news is welcome but negative news will sabotage your trade. The idea here is that you want to sell at the best time with some assurance that the price of the underlying stock will soon after rise thereby causing a decline in the price of the options you just sold. A price rise creates a buffer to absorb minor fluctuations in stock price over the life of the trade. Here is a screenshot of Visa stock with all the technicals aligned correctly on a 333 tick chart.
If the trade was chosen well it will be boring to watch because every day you will make a little more money as your options undergo theta (time) decay. Because you are the option seller theta decay works in your favor. When the days to option expiration are fewer than 30, theta decay dramatically increases until at 4 pm on expiration Friday there is nothing left to decay. If you have arrived at this point and both options are OOM then you have captured the maximum possible gain from your trade. The last trading day for options always falls on a Friday but options do not expire until Saturday. This is merely an inconsequential administrative detail. Expired options are removed from your portfolio automatically and you will notice that funds held by your broker to meet margin requirements will have been released so that you can make a new trade when you are ready.
Variations on the Theme
Depending on personal preference and the strength of the underlying equity the aggressiveness of a trade can be adjusted. Normally when choosing the strike price to trade I would suggest first looking at the premium of the vertical put spread that is two strike prices OTM. To be more aggressive reduce the number of strike prices OTM. Keep in mind that this is more risky and also keep the beta of the underlying in mind when deciding whether to commit to the trade or not. At some point it may be better to simply buy into a long call position rather than a spread position. Similarly, risk can be reduced by selling the spread that is even further OTM.
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