As stocks approach resistance and support levels, you can implement various strategies. The key to success at these times is using the appropriate strategy, given the data available. Implied volatility is a very important piece of information and should play a major role in what strategy you choose. If IV is low at these points, you might choose to enter a directional trade. However, if IV is high, a butterfly or credit spread might be best to use. For this article, we are going to discuss the details of a credit spread, more specifically, a bull put spread.

A credit spread is very simple to set up because it is made up of a short option and a long option, both using the same expiration month. However, we are going to sell the option closest to the support or resistance point, and we are going to buy an option further out of the money. Because we have sold a strike that is closer to the money than the strike we purchased, we receive a credit. We have also capped our max loss so that we are protected if the stock moves sharply in the wrong direction.

For example, let’s assume that XYZ stock is approaching support at $50 a share. We first would want to see where IV is for XYZ options near 50. If IV is above average, than a credit spread might be a perfect fit. In this case, we would be looking at entering a bull put spread using the front-month options. If this trade were entered at the beginning of December, we would look at the December and, possibly, the January options.

When we look up the data for the options, we find that we can get a credit of $1.50 for this bull put spread using the December 50-45 spread. Let’s break this down to see what it means in detail.

For each spread we enter, we receive $150 into our account. However, there is risk here that our broker will want to be covered for. We determined this risk by taking the difference in spreads, which is five points for this trade, and subtracting out the credit of 1.50. This leaves a risk of 3.50 or $350 per spread. This risk would materialize if XYZ were to trade below the breakeven point at expiration.

The breakeven is found by taking the closest to the money strike and subtracting the credit received. In this case, this means 50 less 1.50 or 48.50. If XYZ were to trade below 48.50, we would start to lose money until the stock hit 45 or below. At this point, we would reach our max loss of $350 per spread. Because this is the max risk, your broker will want at least the amount at risk to be held in a margin account.

The advantage to a bull put spread is that, if the stock stays flat or moves higher, you keep the entire credit. Even if the stock falls slightly, you still achieve a profit. The best way to see how a credit spread works is to view a risk graph on eSignal Platinum and do some paper trades. Although credit spreads are not homerun strategies, they are great single hitters that can add up to nice profits over time.