An Example Bull Credit Spread Gone Wrong

And how I turned it back into a profit

This post is a follow up blog post on my other article about my favourite trading strategy, Bull Credit Spreads, you can read it here. I wrote this follow up post to show you what happens when a Bull Credit Spread goes against you and what you can do to turn it into an even more profitable trade.

In this article, we’ll cover:

• What it means when a Bull Credit Spread goes against you
• What I typically do with this trading strategy
• An example of a Bull Credit Spread which I repaired into profit

What does it mean for a Bull Credit Spread to go against you?

So, when you do a Bull Credit Spread, you have written two options on a given equity;

• A Short Put; which obligates you to buy the equity at a given price
• A Long Put; which gives you the right to sell the equity a lower given price.

If we use an example trade of a $50/$45 Bull Credit Spread for company XYZ which we sold to collect a premium of $55;

• You are obligated to buy 100 shares of XYZ at $50 if company XYZ is trading at $49.99 or lower.
• You have the right to sell 100 shares of XYZ at $45 if company XYZ is trading at $44.99 or lower.

So lets go through three examples which take place on the last trading day before expiration of the options:

Company XYZ, is trading at $50.00 or higher.

This is great news, and the outcome which is what we are hoping for when writing a Bull Credit Spread. You can let both options expire worthless, and keep the $55 premium which you collected up front and can move onto the next trade.

At expiration, company XYZ, is trading between $45.00 and $49.99.

Not great news, but not the end of the world. The Long Put which you bought that gave you the right to sell 100 shares of XYZ at $45 will expire worthless and you will be required to buy 100 shares of XYZ at $50.

On the bright side, you still get to keep the $55 premium which you collected up front however you are now faced with a decision that you have to make before the end of the trading day.

• Realize the loss through buying back the $50 Short Put on the market
• Or realize the loss through acquiring 100 shares of company XYZ at a higher price than it is currently trading at.

Let’s say, company XYZ is trading at $47.00 in the last hour of the trading day on the expiration date. Your options will be as follows:

• Buy back your $50 Short Put for roughly ~$300. This will give you a total loss of roughly $245 on the trade (300–55). In this scenario, your hands will be clean of the trade and you can move on to the next trade.
• Let the option expire and be sold 100 shares of company XYZ at $50. Your loss will be exactly $245 as you paid $50/share for 100 shares of stock that are only worth $47, while keeping the $55 premium. However now, you own 100 shares of company XYZ and now have a $5,000 investment in this company. This is significantly more than the $500 you put up front for the trade originally. As you are required to raise your investment here, you only want to pursue this path if you are a believer in the company and are ok with holding it. This is why it’s so important to only use this strategy on companies which you want to own.

For the second option to work, its important to note that you must have the cash/margin available to acquire the stock. This is why it is recommended that you only write Bull Credit Spreads with 25% of your account and make sure the other 75% is available to acquire stock on trades that go against you.

At expiration, company XYZ, is trading below $45.00.

This is the least ideal scenario however it can still be turned around into a profit. In this scenario, you still get to collect the premium of $55 and should you let both options expire, they will cancel each other out and you will realize a $445 loss.

Where you can turn it around is by selling the Long Put back to the market, and be sold the shares of XYZ at $50. To do this you have to be a strong believer in a turn around of the company as you will now be acquiring the stock at well below the strike price which you initially sold at. From here, you move into a covered call writer until you can get the shares called away at $50 or higher.

What do I do?

I only do this strategy on companies which I want to own at a lower price than where I entered the Bull Credit Spread; therefore I usually choose to acquire the stock when the equity is trading below my strike prices.

To put myself in a good position to be able to do this I make sure to leave funds available to acquire stock if a downturn occurs. By doing this I can therefore look at these situations more-so as big opportunities to acquire a stock at a cheap price rather than a loss.

So as promised;

An example Bull Credit Spread gone against me

On July 1st, 2021 I sold a July 16 Bull Credit Spread on MARA, which consisted of a $30 Short Put and a $27 Long Put.

This Bull Credit Spread made me a premium of $110 and I therefore put up $190 (300–110) to potentially make a 58% return on margin in 15 days.

On July 1st, MARA closed at a price of about $30.29. This was therefore a very aggressive trade, which is reflected in the potential return. I also went into this trade knowing that I was ok with having to acquire shares of MARA at a break-even price of $28.90 if I was wrong.

So what happened?

MARA absolutely tanked.

By July 16 it had tanked ~23% all the way down to about ~$23 well below my break even price. I was now faced with the option to acquire 100 shares of MARA/per contract at $30 or let the options expire worthless and realize a $190 loss/per contract.

At this point the stock was trading at strong support, I was a long term believer in the stock (and Bitcoin) and also had the cash available to take on the shares. More importantly, as the stock had been so volatile, options premiums were high and I knew that once I acquired the shares, I could switch into selling covered calls with high premiums that I could collect while I wait for the stock to recover and get my capital back.

So on July 13th I sold my Long Put back to the market for $151 bringing my break even down $27.39 and I left my Short Put open. On July 16th, the short put was exercised against me and my account was debited for $3,000 per contract. I became a bag holder of $30 shares of MARA which were currently trading at about ~$23.

And this is where the magic started..

The next week MARA began to rebound as I was expecting which allowed me to sell calls on my MARA shares. On July 21st I was able to sell the August 6th $31 Call options for $55.

This meant that someone would be willing to buy my shares of MARA back from me at $31 by August 6th, if the stock was trading back above $31. If the stock was trading below $31, I would keep the $55 and the shares. Expanding on this there were two possible outcomes:

1. MARA is trading lower than $31 per share on August 6th:

I could continue to write covered calls, collect income and continue to lower my average cost.

2. MARA is trading above $31 on August 6th:

I would have my shares called away at a significant gain when accounting for all the income from the option premiums and the appreciation in the stock itself. At this point, my average cost per share was at $26.84.

What happened? By August 6th MARA had taken back off and finished the trading day at around $34 and my shares were called away at $31.

This therefore garnered me $416 return per contract written with a total of $3,000 extended per contact or a 13.87% return in just over a month.

Had I just bought 100 shares of MARA stock on July 1st, I would have had to extend $3,029 for the entire time, suffer through the position being down almost 30% and would have walked away with roughly the same gain on August 6th.

Instead I was able to make roughly the same amount but was also able to achieve a break-even price of $26.84 rather than $30 compared to the outright purchase of the shares. I only experienced a 12% drawdown and this put me in a much better position had MARA not had such an aggressive come back by August 6th, compared to buying the equity out right.

All this goes to show how it is possible to take losing Bull Credit Spread trades and turn them into winners when you write Bull Credit Spreads on companies which you want to own and have the funds available to take ownership.

Additional Reading

Did you miss my first post where I explain what a Bull Credit Spread is? Check it out here.