When it comes to trading, one of the most important factors to understand— in my opinion — is risk-reward.
Many successful traders will calculate their risk in relation to the potential reward when they consider entering a trade. Now, I’m no different whenever I trade options spreads.
Before I get into any trade… I know how much I’m risking and my potential reward when I first establish a position.
With options spreads, more specifically — credit spreads, I like to weigh the risk-reward so I know how to size my position properly in relation to my account size.
So how do I do it and why do I believe it’s so important?
How To Figure Out Risk-Reward With Credit Spreads
Now, when it comes to risk-reward… I believe the idea is simple. Basically, I want to know how many dollars I’m risking in relation to the dollar amount I can potentially make. For example, if I’m in a position and my downside is $2,000, but my maximum profit potential is $2,500 — that means for every dollar I’m risking, my potential reward is 1.25.
When it comes to options spreads, it’s a little bit different. First, you would have to figure out the maximum potential profit and the maximum loss. Typically, your broker or options trading platform would calculate this. However, if it doesn’t, that’s okay.
Now, I’m going to show you how to do this with the short put spread, also known as the bull put spread. If you’re interested in learning more about credit spreads, then click here to receive my complimentary options trading eBook.
Calculating Risk-Reward For The Bull Put Spread
When it comes to the bull put spread, traders typically use this when they believe a stock may stay above a certain level and run higher. The thing with credit spreads is the risk is defined, as well as the potential profits.
Here’s a look at the risk profile of the bull put spread.
As you can see, at some point, the strategy can either reach the maximum loss or maximum profit.
Now, how do you calculate the maximum profit?
Maximum Profit For The Bull Put Spread
The maximum profit potential for the bull put spread is the net credit received when the strategy was setup. So let’s say you received $1.50 to establish the bull put spread… then the maximum loss would be limited to $1.50.
Keep in mind that options have a multiplier of $100, so for each contract, you sell the maximum profit is actually $150. If you sell 10 contracts, the maximum profit is $1,500.
Bull Put Breakeven Point
I think it’s also important to know where the breakeven point is. For the bull put spread, the breakeven point occurs at strike B less the net credit received when establishing the position.
For example, let’s say you sold a $50 put in a stock and simultaneously purchased the $45 put (to hedge the short put position) for a net credit of $1.50.
That means the breakeven point would be at $48.50 ($50 less $1.50).
Now, knowing the maximum risk in a credit spread is highly important.
Maximum Loss For The Bull Put Spread
On the other hand, the maximum potential loss is calculated differently. The risk for a bull put spread is limited to the difference between strike A and strike B, less the net credit received.
So let’s continue with the hypothetical example from before.
The difference between the $45 / $50 put spread is $5. Thereafter, you would just subtract the net credit received from $5. That means the maximum loss is $3.50, or $350 per contract.
If you do the math, one would risk $3.50 to make $1.50.
I know what you’re probably thinking… why would anyone want to use this strategy if the risk outweighs the reward?
Why do I say that?
The thing is, I can profit in 3 different ways…
- If the stock runs up, I can profit.
- If the stock stays in range, but above the price at which I sold the puts (in the example I used, it would be $50)… I stand to profit.
- Even if the stock falls a little, but stays above $50, I can still profit.
Not only that, but time is on my side when it comes to credit spreads.
Now, if you want to see how I use credit spreads and set myself up for success, then click here and watch my options trading masterclass.