We normally expect our stocks to increase in value, not decrease. That's why the last few years have seemed anything but normal -- and why you should be familiar with a strategy known as a bear put spread.
As the name implies, this is a put used when you're bearish on a stock. Whether you expect a specific stock or most stocks to be heading south, a bear put spread can come in handy. And even if you're neutral or even slightly bullish on a stock, the returns from a bear put spread can be attractive.
Finally, as a method of diversification, you might want to use a low-cost bear put spread as protection against other more bullish positions on a particular stock.
How to Construct a Bear Put Spread
The bear put spread is constructed by purchasing a put and then selling another put with a lower strike price, but with the same month of expiration. This will result in a debit trade (money will come out of your account to enter the trade), and this debit will be the maximum loss that you can incur in the trade.
At first glance, this may appear to be a case of buying high and selling low. However, because the put actually increases in value as the stock price drops, you're creating a trade in which you're actually buying at the low price and, if the stock falls in value, the bear put spread will increase in value.
Stocks tend to fall in value faster than they go up, so the bear put spread is generally a short-term trade. Therefore you'd want to put the trade on with less than 45 to 60 days before expiration. In addition, you'd want a stock that has some further room to fall, not one that is bouncing against a price of zero. You would generally want a stock with a price of at least $15 to $20, the higher the better.
The maximum profit on a bear put spread is calculated as follows: the difference in strike prices of the long and short puts less the net debit, times the value per point ($100 in the case of stock options), times the number of spreads purchased.
The maximum loss of the trade at expiration is simply the net debit of the trade times the value per point ($100 in the case of stock options) times the number of contracts.
Example in the Pharmaceuticals Industry
If you are looking for a bearish trade, you first need a stock that you believe will actually lose value over the next period of time. Of course, the best place to look for downward-trending stocks is among those sectors that have a downward bias already.
One such sector that has been falling in value recently is the drug sector, and within that sector is a company called
. On Thursday, June 20, the stock closed at $33.98, down almost 50% over the past three months. On its price and volume chart, you'll see it has a nice, strong, downward trend on increasing volume. As the stock is trading at $34, there's certainly room for it to have a further downward move.
Idec's focus is targeted therapies for the treatment of cancer and autoimmune and inflammatory diseases. It has a joint business arrangement with
. Sales were $79.7 million for the quarter ended March 31, and net income was almost $30 million in the same period. This is not a fly-by-night drug company, but rather one that is small, dependent on only two drugs, and being pulled down with the general market meltdown in the drug industry.
After deciding that this is a good candidate for a bear put spread, you then must estimate how far down the stock is likely to fall in the next 30 to 60 days. This will determine just which bear put spread (or spreads) you might look at. If you believe Idec can easily fall to $25 by July's expiration, then you can look at the available options for a bear put spread. From the CBOE Web site, the options and their associated prices are given in Table 1.
|Idec Pharmaceuticals Price List
Selected options and their related bid/ask prices from the CBOE Web site on June 20
|02 Jul 40 Put
|02 Jul 35 Put
|02 Jul 30 Put
|02 Jul 25 Put
From these options, you can actually construct six bear put spreads. Here are the various bear put spreads in descending order of break-even (one measure of increasing risk).
|Bear Put Spread Choices for Idec Pharmaceuticals
In descending order of break-even
|Bear Put Spread
|Jul 40/35 Put
|Jul 40/30 Put
|Jul 40/25 Put
|Jul 35/30 Put
|Jul 35/25 Put
|Jul 30/25 Put
Theoretically, you would now select one to trade. If you're very conservative, you'd choose the July 40/35 put spread, where you would purchase the 02 Jul 40 put and sell the 02 Jul 35 put for a net debit of $3.80 per share, or $380 per spread. This would give you a 32% maximum profit, which comes if the stock closes at or below $35 on July 19. Because the stock was recently selling just under $34 a share, you're already at the maximum profit point. In fact, the stock could actually increase by $1 and you would still garner the maximum profit on this trade! The underlying stock could increase almost $2.25 (7%), and you would still be profitable.
On the other hand, if you wanted to swing for the fences and were willing to take the most risk, you could enter the Jul 30/25 put spread for $115 per spread. This bear put spread has a potential profit of $385 per spread (335%) if Idec were to fall below $25 by July 19. In this particular trade, the stock must fall $9 per share (26%) in the next four weeks to make the maximum profit, and in fact, it must fall more than $5 just to break even. Of course, the other four trades fall somewhere in between these two extremes.
Which trade should you choose? Depending on your belief in the weakness of the stock price and your tolerance for risk, you could choose the Jul 30/25 bear put spread and pull in a spectacular 335% return in just one month if you are correct in how far and how fast Idec will fall. However, the much less risky position (Jul 40/35 bear put spread) is no slouch either. The stock can actually increase in value by $1, and you would still get the maximum return (32%) on the trade. If you could do this every month, 32% compounded monthly would result in an original $3,800 (10 original contracts) growing to more than $10,600. Of course, this doesn't account for commissions and taxes, but even so, the returns would sure beat the average (or even above-average) mutual fund.
These trades are generally designed to go until expiration. Even if the stock moves significantly in the first few days of the trade, the time value in the options will generally be so high, and the slippage between the bid and ask prices so great, that there is little, if any, increase in the value of the spread. However, this can actually be used to your advantage. If the stock moves sharply against you, especially early on in the trade, you can usually exit the position (buy back the short put and sell the long put) without too much of a loss.
The basic exit criteria are as follows:
If the stock moves sharply one direction or the other early in the trade:
If the stock moves sharply down in price early in the trade, look at the net price of the spread and exit it if you have roughly 70% to 80% of your expected profit. In this trade, you would be looking to make about 85 cents per share, or be able to sell the spread for $4.65 or more. As you spent $3.80 to enter the trade, you would be exiting with a 22% profit, and not risking losing it all by an equally sharp run-up in the last days of the spread.
If the stock moves sharply up in price early in the trade, exit the position as soon as possible. Obviously the stock is not doing what you expected it to do, and hence you should get out. Waiting will only increase your losses, up to the maximum of your debit.
As you approach expiration day:
If the stock has moved below the short put, buy back the short put and sell the long put for 80% of the maximum profit or more. The closer you are to expiration, the more of the profit you will capture.
If the stock is between the short and the long puts, you must decide just when to exit. If you wait until closing on expiration day, you can simply let the short put expire worthless and sell the long put. That will save you one commission and one bid/ask spread slippage. As long as the stock price is below the break-even price, you will make a profit. As the stock price closes above break even, you will lose more and more money up to the maximum of the debit of the trade -- when the stock price is at or above the strike price of the long put.
If the stock price is right at or slightly above the strike price of the long put, you are in the maximum loss position. You can:
Let both options expire worthless, taking the full loss of the debit.
Sell the long put (going naked, of course, on the short put for a day or so) if there is any time value left in the long put. This, of course, is quite risky due to the naked short put.
Exit the entire position, selling the long put and buying back the short put.
Morph the trade into a bull put spread by selling the long put and purchasing a put with a strike below the strike of your original short put for a net credit. This will often work if the stock hasn't moved too far above the strike of the long put, if your outlook for the stock has switched from bearish to bullish, and if there is still some time left (several days to a week) before expiration.
The bear put spread tends to minimize the effects of the so-called Greeks on the trade. Because you are both buying and selling premium, the tendency is for the impact of the Greeks on a trade to be basically, though not totally, neutralized.
Delta (rate of change):
Delta, or the rate of change of the option price with a small price change in the underlying, will be almost neutralized by the spread. Because you are both long and short a put, and the puts are relatively close together, there will be almost as many positive as negative deltas in your position. This is primarily why the trade doesn't move much with daily price changes of the underlying. For instance, in this trade the long put (02 July 40 put) has a delta of -74.330, while the short put (02 Jul 35 put) has a positive delta of +49.705. Netting the position, you get a net delta of -24.625: not exactly delta neutral, but two-thirds closer than if you simply purchased the put.
Theta (time decay):
Time decay is both working against you (the long put) and for you (the short put). The resulting combination will depend on just which options you buy and which options you sell. If you recall the bell-shaped curve of time value around the at-the-money (ATM) options, you will recognize that there will be more time value in options ATM and less in options that are either in the money (ITM) or out of the money (OTM). As you are buying a slightly ITM put and selling one that is close to ATM, time value will actually be working just slightly in your favor in this particular example. However, a different selection (say, the 02 Jul 30/25 bear put spread, for instance) would have time value working slightly against you.
As with theta, you are both buying and selling volatility. Unless there is a significant skew around the monthly options, you will be buying and selling about the same amount of volatility. Thus, the bear put spread will be relatively insensitive to small movements in the price of the underlying. This is both good and bad. It is good in that your position will not bounce all over the map with every price change of the stock. This will help in entering and exiting the position, in that a net price for the spread, once determined, will not change much in its value over the following few minutes, regardless of the fluctuations in the stock price. On the other hand, a quick drop in the stock price may not make much of a corresponding run-up in the net value of the spread. Thus, you'd need to hold the position until it gets close to expiration, or the stock must move
significantly for you to prosper.
You can improve the probability of success of a bear put spread by looking for companies in troubled industries. Just as the euphoria of an upward-trending sector will tend to pull all stocks in that sector up with it (even the weaker stocks), so too will a downward-trending market segment tend to drag down all stocks in that segment, even the better ones. Thus, even if you do not choose the worst possible stock, a down segment will tend to keep downward pressure on your stock and help out the trade. Because a bear put spread is basically a short-term trade, it is generally simple to find a sector that has significant downward pressure on it that will stay negative for the next 30 to 60 days.
A second improvement on just blindly putting on a bear put spread is to look at the pricing of the option. By only selecting those options that are underpriced (to buy) and overpriced (to sell), for any given stock, the reward/risk ratio can be improved. To determine the correct pricing for any given option, you will need to acquire the use of an option calculator. You want to calculate the implied volatility (IV) of each option, selling those for which the IV is high and purchasing those whose IV is low. While a large skew is not often found, when you do, it magnifies your returns. Such a calculator is found on
, among other places.
The bear put spread is a very useful trading strategy in your arsenal. There are times when the stocks you want to trade just are not going up, or even staying neutral, and this simple trade will permit you to prosper even as your fellow traders are sitting on the sidelines, or even losing money.