What is a Bullet Trade?
A bullet trade allows an investor to participate in a stock's bearish move, without actually selling the stock, by buying that stock's in-the-money (ITM) put option.
- A bullet trade is a secondary market trade that involves the act of purchasing an in-the-money option on a security so that the option buyer can effectively capitalize on the move in the underlying security without, in some instances, waiting for the exchange mandated price change.
- Bullet trades are predominantly associated with bearish markets.
- For example, a bullet trade allows an investor to participate in a stock's bearish move, without actually selling the stock, by buying that stock's in-the-money (ITM) put option.
Understanding Bullet Trade
A bullet trade is a secondary market trade that involves the act of purchasing an in-the-money option on a security so that the option buyer can effectively capitalize on the move in the underlying security without, in some instances, waiting for the exchange mandated price change.
Bullet trades are predominantly associated with bearish markets. An investor wants to sell his stock or participate in the price decline of a stock, but regulations require that there has to be a price tick higher before they can sell their stock or initiate a short sale. The investor can buy an in-the-money put option, which allows them to capitalize on the decline in that security's price.
A bullet trade is a strategy commonly used by investors that wish to speculate on price changes. There may be several scenarios where a bullet trade would occur. The concept of a bullet trade is based on the availability of immediate profits. The two most common include buying an in-the-money put option or an in-the-money call option. All option trades require access to derivative trading through a broker or brokerage platform.
For example, consider a bullet trade scenario where the security's price is declining and the investor buys a put option to capitalize on the move lower. The owner has two variables to consider, namely the price of the option and the price of the underlying security. The put option owner profits from the difference in strike price and market price, minus the cost of the put option. After buying the put option, the owner has multiple options. The owner can immediately profit on the exercise of the option. They may also watch the market prices for decreases before exercising. In this scenario, to obtain the greatest profit, a put option owner would want to exercise when they believe the security has reached its lowest possible point.
In-the-Money (ITM) Put Option
To execute this trade, an investor buys a put option that is in-the-money. The put option gives the investor the right, but not the obligation, to sell the specified security at the specified price. Put options come with many terms. Put options will have a specified exercise price also known as a strike price. There is a cost associated with buying a put option through a broker. Put options are not required to be exercised, which puts the upfront cost, called premium, as the amount that the investor is risking. The investor can also specify the option's expiration date, which is a time frame for executing that put option.
Buying an in-the-money put option is the key to a bullet trade’s profit. An in-the-money put option refers to a put option with a strike price that is higher than the market’s current price for the underlying security. Technically the strike price must be higher than the market price plus the option’s cost (premium). This allows the put option owner to generate a profit from exercising the option.
To exercise the option the put owner would need to buy the security at its market price and then sell to its option counterpart at the strike price. Generally, the put owner would also be liable for any trading costs associated with the buying of the underlying security for execution, which also factors into the profit.
In-the-Money (ITM) Call Option
To execute this trade, an investor buys an in-the-money call option. The call option gives the investor the option to buy a specified security. Call options also come with many terms, including a specified exercise price, a fee, and a specified time frame to expiration.
Buying an in-the-money call option refers to a call option with an exercise price that is lower than the market price. This allows the call option owner to generate an immediate profit from the option. In an in-the-money call option bullet trade, the call option owner would need to exercise the option, obtain the security, and immediately sell it in the secondary market. This scenario includes more trading costs, which requires wider spreads in order to profit.