If the large potential loss of selling a naked put scares you, a bull put spread might be an alternative to consider. This strategy offers a risk-limited way to bet on a stock rising, even with a small trading account. Using Option Samurai’s options screener, you can find solid trading ideas, and our free bull put spreads backtest gives you a trading edge by evaluating past data. Read on to learn more about how this works: we’ll give you an example, and you’ll find a link to access the backtest file at the end of the article.
Key takeaways
- Bull Put Spreads offer a risk-defined way to bet on a stock going up that even a beginner with a small trading account can use.
- Using Option Samurai’s options screener, you can find great trading ideas for bull put spreads on solid companies.
- Our free backtest gives you a trading edge by letting you run an empirical analysis to evaluate the past behavior of an underlying stock or ETF.
What is a Bull Put Spread?
Before we look more closely at the trading edge that our backtest can give you, we should spend a few words about the bull put spread strategy.
Definition and Basic Mechanics
A bull put spread is an options trading strategy that involves two steps:
- Selling a put option at a higher strike price.
- Buying a put option at a lower strike price.
Both options have the same expiration date. This creates a net credit (you receive money upfront) and sets up a position where your maximum profit is limited to the initial credit received, and your maximum loss is limited to the difference between the strike prices minus the net credit. Just as a preview, here is what the typical P&L of this strategy will look like (you will gain more confidence with its shape as we progress with the article and our examples):
Why Traders Use This Strategy
Traders use the bull put spread for several reasons:
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- Risk Management: This strategy offers a risk-defined way to bet on a stock rising. The potential loss is capped, making it less risky than selling a naked put.
- Profit from Time Decay: As a credit spread, the strategy benefits from time decay. As the options approach expiration, their value decreases. The time erosion of the put you are selling should more than compensate for the loss in value of the put you are buying: a win-win situation.
- Small Account Friendly: This strategy requires less capital compared to buying stocks or using other options strategies, making it accessible even for traders with smaller accounts. In fact, you will notice that your broker will normally require an investment margin equal to the maximum loss you could experience. Try and compare it to what your broker asks for a margin when you simply sell a naked put (we’re guessing a much, much higher amount of money), and you’ll understand what we mean.
- Good profit probability: You could also think of a bull put spread as a strategy with high profit probability because you are working on OTM contracts, and time is on your side.
The Trading Edge You Can Obtain with Bull Put Spreads Analysis
We do not only write about options trading; we are options traders ourselves. Therefore, the tools we give you are tools that we develop and test for ourselves, first of all. So, what is our intuition about the edge you can obtain with a bull put spread backtest?
The Trading Edge
When you consider past performance with bull put spreads, you gain a significant advantage. Let’s say you find a bull put spread that will be profitable in case the underlying stock does not drop by 5% within the next two weeks.
Using our options screener, you can estimate your profit probability based on current option prices. To validate this, you can run your own backtest. Wouldn’t it be insightful to see how often the stock price decreased by 5% in a two-week span?
Practical Application
This method works especially well with solid companies. We recommend combining this backtest with our “Sell Out-The-Money put spreads (Good Companies, Margin of Safety)” predefined scan (we’ll add a link for you at the end of the article). Running a statistical analysis on reputable companies ensures more reliable results.
Trying this with troubled companies may not yield the desired outcomes. Remember: you’re not asking the backtest to pick a bull trade for you. This is something you should do on your own by evaluating how solid a company is and what the market thinks of its fundamentals. The backtest should only validate your choice to better time the trade.
Using a bull put spread backtest, you can confidently evaluate past performance and enhance your trading strategy, aligning your decisions with historical data for better-informed trades.
The Intuition Behind the Backtest – Good Companies and Past Performance
The best way to understand what we want to achieve with this bull put spread backtest is to quickly give you an example without going too much into detail. This will simplify the reading of the deeper practical example in the next section.
Example: FDX Bull Put Spread
Let’s look at FedEx Corporation (FDX), currently trading at $248.09. Suppose you spot this bull put spread opportunity:
Here is what you should take away from the image above:
- Buy a $220 put and sell a $235 put expiring in 9 days.
- In order to have a profit, the stock price needs to remain above the -6.36% threshold until expiration.
You might choose this trade because FDX is a solid stock. Even though an earnings report is due before expiration, let’s say you ran your research and you know that FDX generally performs well on these occasions.
Insights from Our Google Colab Backtest
Our backtest reveals several key pieces of information for this trade:
- Historical Performance: How often did FDX remain above the breakeven percentage threshold of the trade considering the time window selected by the user (in our case, 9 days)? This happened 91.23% of the time.
- Profit Ratio Analysis: What is the minimum profit ratio required for the trade to have a positive expectancy? Our options screener indicates a profit ratio of 21.75%. We will not bore you with the math, but, in short, you want your profit ratio to be higher than: (1/profit likelihood) -1. Therefore, you’d need a profit ratio above 9.6% (1/0.9123 = 1.096, and 1.096 – 1 = 0.096) to have a positive expectancy from a statistical perspective.
Also, take a look at the price chart that our backtest gives you:
Here is how you should read the chart: a look at the historical stock price and the phases when FDX dropped below the required threshold. The red dots in the graph show all instances where FDX moved below the percentage threshold needed for this trade to be profitable.
Why This Matters
- Solid Company: As part of our predefined scan, FDX is indicated as a good company with solid growth and earnings.
- Probability and Backtest: The scan approximates the probability of maximum profit at 81.01%. Our backtest suggests it may be even higher, above 90%.
- Earnings Consideration: Keep in mind that FDX will release earnings before expiration, potentially leading to extreme scenarios. If you are uncomfortable with this risk, that’s okay: rerun the analysis on a trade opportunity not affected by earnings.
By using a bull put spread backtest, you can gain deeper insights and make more informed trading decisions.
Using Our Backtest File
Here’s a step-by-step guide to using our bull put spread backtest file to validate your trading ideas.
Step-by-Step Instructions
- Access the Predefined Scan: Go to our predefined scan mentioned at the bottom of this article. This scan is designed to find good companies that are likely to be stable and solid investments for bull put spreads.
- Conduct Research: Run your own research on the companies listed in the output of the predefined scan. Look for companies that you believe have strong fundamentals and positive future prospects.
- Isolate Good Companies: Narrow down your list to a few companies you find promising (our scan does this already, but running your own analysis is a way to strengthen your understanding of the trade idea. For each company, identify the corresponding bull put spread trade idea highlighted by our options screener.
- Note Down Trade Information: For each trade, note down the following information:
- Ticker: The stock symbol.
- % Threshold for Profit: The percentage threshold at which you will make a profit.
- Days to Expiration: The number of days until the options expire.
- Access the Google Colab File: Now, go to the Google Colab file linked at the bottom of this article. This file is where you will input your trade details and run the backtest.
- Create a Copy of the Colab File: You need to create a copy of the Colab file to save your changes and runs. Click “File” in the menu and then “Save a copy in Drive” to create a personal copy in your Google Drive account.
- Input Trade Details: Open your copied Colab file and input the trade details at the top of the document. Specifically:
- Ticker: Enter the stock ticker.
- Days to Expiration: Enter the number of days until the options expire.
- Breakeven Percentage: Input the percentage threshold needed to make a profit (e.g., if you need the stock to stay above a -10% variation, enter “-10”).
- Starting Year: Choose a starting year for your backtest. We recommend using a sufficiently large dataset (e.g., starting from 2010) to capture multiple market cycles.
- Run the Backtest: Once you’ve entered all the necessary information, it’s time to run the backtest. Click the “Runtime” menu at the top of the Colab interface and select “Run All.” The script will execute, and after a few seconds, you will receive the analysis results.
Understanding the Results
The backtest will provide you with several key pieces of information:
- Frequency Above Breakeven: This tells you how often the stock remained above the breakeven threshold over the specified period.
- Profit Ratio Analysis: The minimum profit ratio required for the trade to have a positive expectancy. Compare this to your trade’s profit ratio to ensure it meets or exceeds the requirement.
- Recent Historical Context: Recent instances when the stock price fell below the breakeven threshold, helping you understand recent volatility patterns.
- Visualization: A price chart with red dots indicating when the stock moved below the threshold within the selected timeframe. This visual aid offers a quick overview of the frequency and context of price drops.
A Real-Life Example of Bull Put Spread Validated by Historical Performance
Let’s dive straight into a detailed case study of a successful bull put spread trade using Starbucks (SBUX) as our example.
Trade Setup
On the day of our analysis, Starbucks (SBUX) was trading at $77.13. Recognizing Starbucks as a solid company with promising future prospects, we decided to use our options screener to find a suitable bull put spread opportunity.
As you see above, the chosen trade setup was as follows:
- Buy a $71 put
- Sell a $73 put
- Expiration in 31 days
In the worst-case scenario, this trade would result in a loss of $150, while the potential profit is $50. This equates to a profit ratio of 33.33%. The breakeven point for this trade is $72.50, meaning the stock price needs to remain above a -6% variation by the time the options expire.
Running the Backtest
To validate this trade, we used our Google Colab file and inputted the following details:
- Ticker: SBUX
- Days to Expiration: 31
- Breakeven Percentage: -6%
- Starting Year: 2010 (to ensure a robust dataset covering multiple market cycles)
Specifically, you would add the information above here:
The backtest results provided key insights. First of all, the frequency of the stock remaining above the breakeven percentage over the specified time horizon was 84.48%:
Second, for positive statistical expectancy, the profit ratio must be above 18.37% (which is 1/0.8448 – 1). And remember that our trade’s profit ratio of 33.33% comfortably exceeds this threshold.
Additionally, a price chart marked with red dots indicated all instances where the SBUX price moved below the 6% threshold within the 31-day timeframe:
This visual representation provides a quick overview of how often such drops occur.
The Final Interpretation of Your Backtest
Reviewing the historical performance data, we observed that Starbucks has consistently maintained its value over short-term periods, seldom dipping below significant thresholds. The backtest confirmed that in 84.48% of instances, SBUX remained above the -6% variation threshold within a 31-day window. This high percentage underscores the stability and resilience of Starbucks, making it an ideal candidate for this bull put spread strategy.
The key takeaway from the historical performance is the alignment of the trade’s profit ratio with statistical expectations. With a required profit ratio of just 15.52% for positive expectancy, our trade’s 33.33% ratio provided a nice margin for success. And note: this is only a statistical analysis, make sure you add a company-based research phase to support your trade, or this study will remain a purely mathematical exercise that doesn’t take into account other critical factors.
Understanding the Historical Performance Methodology (and Its Limitations)
Keep in mind the following aspects when evaluating the backtesting operation described in this article.
Backtesting Methodology
- Backtesting is a statistical method of evaluating a trading strategy by applying it to historical data.
- In our example, we used the Google Colab file and inputted specific details such as the stock ticker, days to expiration, breakeven percentage, and starting year.
- The backtest then runs through each day of the specified timeframe and calculates the performance of the chosen trade setup.
- This methodology allows us to understand the historical frequency and context of price drops below a certain threshold.
Accuracy and Reliability of Historical Performance Data:
- The accuracy and reliability of historical performance data can vary depending on the quality and consistency of the data source. In our case, we used a robust dataset covering multiple market cycles, but errors can happen. (remember that, for SBUX, we made it so that the analysis began in 2010) to ensure more accurate results.
- However, it’s important to note that past performance does not guarantee future results. This is why you should be smart about it and only select really solid and good companies to execute your trades.
Potential Pitfalls and Limitations
- Backtesting relies heavily on historical data, which may not always accurately reflect current market conditions or unexpected events (e.g., think about what stocks did during the COVID-19 pandemic, a social and economic scenario we have never seen in modern history).
- It also assumes that the trade setup will be executed flawlessly without any slippage or other factors impacting its performance.
- Additionally, backtesting does not take into account company-specific factors such as management changes, product developments, or industry trends. This is part of each trader’s due diligence to research beyond just the statistical analysis.
- It is very important to remember that the backtest isn’t meant to replace your judgment but to help you learn from the past. A million things could go wrong with a trade, and while backtests are useful, they can’t show them all, and they are not without problems.
It’s important to combine backtesting with other fundamental and technical analysis methods to make well-informed trading decisions. Regular monitoring and adjustments are necessary as market conditions and company fundamentals are ever-changing.
