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.
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).
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.
Optionetics.com , among other places.
How to Construct a Bear Put SpreadThe 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 IndustryIf 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 Idec Pharmaceuticals ( IDPH). 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 Genentech ( DNA). 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||$6.70||$7.20|
|02 Jul 35 Put||3.40||3.80|
|02 Jul 30 Put||1.45||1.70|
|02 Jul 25 Put||0.55||0.80|
|Bear Put Spread Choices for Idec Pharmaceuticals |
In descending order of break-even
|Bear Put Spread||Debit||Max Profit||% Return||Break-even|
|Jul 40/35 Put||$380||$120||32%||$36.20|
|Jul 40/30 Put||575||425||74||34.25|
|Jul 40/25 Put||665||835||126||33.35|
|Jul 35/30 Put||235||265||113||32.65|
|Jul 35/25 Put||325||675||208||31.75|
|Jul 30/25 Put||115||385||335||28.85|
Exit CriteriaThese 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.
- 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.