Earlier this week, Income Masters members closed their second profitable spread trade on Generac Holdings (GNRC) in less than a month.
Generac is a leading designer and manufacturer of standby and portable generators that is expected to be free cash flow positive this year.
Both times we’ve traded the stock in the past month we’ve used a bull put spread strategy, and the returns have been excellent.
A bull put spread, also known as a put credit spread, involves selling a put option and purchasing a put option at a lower strike price with the same expiration date to generate a net credit.
The maximum profit is the credit received and is achieved if the top leg finishes out of the money (OTM). While the profit is capped, so is your risk. The most you can lose on the trade is the width of the spread minus the credit received.
Source: Option Alpha.
In addition to limiting risk, bull put spreads offer leverage, allowing you to potentially book high rates of return on the limited capital required. Just look at what we earned on our recent GNRC trades:
Now, obviously, those are some eye-popping annualized rates of return. And there’s almost no way you could turn your capital around in a way that would achieve them. But they are helpful for the purpose of comparison and to illustrate the power of trading spreads.
Even looking at the absolute rates of return, I doubt anyone would complain about making a 12% to 14% return on their capital commitment — which was just $500 per spread — in a one-to-two-week period.
Now, the day after we closed our latest GNRC trade, an Income Masters member asked about continuing to hold the spread through expiration. At the time of the question, the top leg of the spread was about 6.8% out of the money.
My response was that, of course, the member could continue to hold if they wanted to, but that there were a few things to be aware of.
First and foremost was the chance of a market sell-off before Friday’s expiration due to disappointing earnings from some big tech companies and/or the Federal Reserve signaling it will raise rates for longer than currently expected.
Further, I noted that GNRC is prone to larger swings, meaning 6.8% may not be as much of a cushion as it is with lower-volatility stocks.
Finally, I pointed out that the company reports earnings next week, on Aug. 2. If the stock reverses and the spread goes in the money (ITM), they would be forced to close at a loss or roll out past the earnings date.
While the company has exceeded earnings estimates in 11 of the past 12 quarters, there’s no guarantee this will be the case this quarter or that we won’t see a post-earnings sell-off even if it does beat.
I closed by saying that if the member was comfortable with managing the position with earnings on the horizon to be sure to watch the trade closely so they could act quickly if needed.
While we were happy with our 14.4% return, how someone ultimately chooses to manage their positions is a personal decision based on things such as their risk tolerance and commission structure.
But what is clear from our GNRC trades is that bull put spreads offer a way to make very high returns on a smaller amount of capital while limiting their risk.
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