Wednesday, 8th September 2010

Bearish Spreads

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
February 11, 2010

Why use bearish spreads?

  • To profit on a falling stock or index while capping your risk.
  • To earn strong percentage returns on a moderate move in an underlying investment.
  • To lower the cost of bearish put option purchases.

Earlier we introduced spreads — specifically Bull Call Spreads — explaining how they involve simultaneously buying and writing the same type of option (either calls or puts) on a stock, usually with a “spread” between the two strike prices. You can set up bullish, bearish, or neutral spreads, and they can be defensive or aggressive.

At Motley Fool Options, we’ll likely use bearish and neutral spreads more often than bullish spreads. Why? When you’re bearish and want to go short, it’s important to limit your risk. That’s exactly what spreads do — though they cap your potential profit in the process. When you’re bullish, it can pay to have unlimited upside potential and it’s less important to limit risk, sometimes making spreads a less appealing strategy. There are three key bearish spreads we’ll consider here, so let’s go over how they work.

Bear Put Spreads

The most common bearish spread involves buying a higher-strike put and financing some of the purchase by writing a lower-strike put with the same expiration date on the same underlying stock. The put you purchase will appreciate in value if the underlying stock declines. Since our potential loss is 100% of the capital we invest, we prefer setting up bear put spreads that can return at least 50% to 100%, making the risk worthwhile. Ideally, we’ll do this using strike prices that are within 20% of the current share price so we’re not reaching too far.

Bear Put Spread Specifics
Action: Write (“sell to open”) a lower-strike put and buy (“buy to open”) a higher-strike put (usually, but not always, straddling the stock price).
Trade type: Net debit; you always pay out to set up the trade.
Maximum loss: The amount you pay to set up the trade. This occurs when the stock ends above the strike of your higher-strike put.
Maximum profit: The difference between your two strike prices, minus your initial debit. This occurs when the stock ends at or below the strike of your lower-strike put.
Break-even price: The higher strike price minus your initial debit.

Let’s walk through an example. Suppose a retail company that sells poorly made, overpriced products is trading at what you deem a too-high $30 a share. The stock appears ripe for a decline, so you set up a bear put spread, buying $33 puts, which cost $5, and writing $28 puts, which pay $2.50, for a net debit of $2.50 per share. Since $5 separates the two strikes, the most you can make is $2.50 per share ($5 minus the $2.50 debit), or double your investment. The most you can lose is $2.50 per share as well. Your break-even price is $30.50, and if the stock falls below $28 by expiration, you make the full 100%; if it trades above $33, you lose your full investment. By choosing your strikes carefully and making sure the options pay a reasonable price, you’ve set up a bear put spread with strong profit potential.

To be especially defensive, you could set up a bear put spread with strikes above the current share price: In this case, you could buy $36 puts and write $32 puts on the $30 stock. As long as shares stay below $32, you’ll earn the full amount possible on your spread. However, defensive spreads usually don’t pay much. On the flipside, an aggressive bear put spread would use strike prices below the current share price, such as buying $28 puts and writing $25 puts. The $30 stock needs to fall below $25 for you to earn the full profit, but the profit will be handsome.

Usually, we’ll write moderately minded bear put spreads, similar to our first example.
Bear Call Spreads

Yes, Fools, you can use call options to make outright bearish investments. Bear call spreads have a compelling draw: You start with a net credit to your account. To set one up, you buy calls at a higher strike, and then write calls at a lower one. (Since lower-strike calls are always worth more, you always start this trade with a net credit.) As with all spreads, one side of your trade protects against the other, capping your risk.

Bear Call Spread Specifics
Action: Buy (“buy to open”) calls with a higher strike, and write (“sell to open”) calls with a lower strike.
Trade type: Net credit; you’re always paid to set up the trade.
Maximum loss: The difference between your two strike prices, minus your net credit.
Maximum profit: Your original net credit.
Break-even price: The lower strike price plus the credit received.

Let’s assume you set up a bear call spread on the same $30 retailer from our bear put spread example. You buy calls at $33, which cost you $2, and then write calls at $28, which pay you $4; your net credit is $2 per share. If the stock ends below $28, both calls expire and you keep the $2 per share. If it rises above $33, you’d close both calls before expiration, and your cost would be the difference between the two strikes, or $5. Given your $2 credit, you’ve lost the maximum $3 per share.

Stock Price at Expiration Buy $33 Call for $2; Value at Expiration Write $28 Call for $4; Value at Expiration Bought Call Profit at Expiration Written Call Profit at Expiration Total Spread Profit at Expiration
$28 or lower $0 $0 ($2) $4 $2
$29 $0 $1 ($2) $3 $1
$30 $0 $2 ($2) $2 $0 (break even)
$31 $0 $3 ($2) $1 ($1)
$32 $0 $4 ($2) $0 ($2)
$33 $0 $5 ($2) ($1) ($3)
$34 $1 $6 ($1) ($2) ($3)
Every price above $34 ($3)

To be most defensive, you would use strike prices above the underlying share price, or both out-of-the-money. This way, even if the stock goes up, as long as it stays below the lower of the two strikes, the spread will end profitably. Aggressive bear call spreads are rare (since bear put spreads work better for strong bearish cases), but these are initiated with both strikes below the share price.

Bear call spreads are popular because they start with a net credit, but they have disadvantages compared with bear put spreads. First, if you write an in-the-money call (which your lower-strike call often is), an early exercise will derail your strategy. Second, calls tend to hold time value longer than puts. A bear call spread will not respond as quickly as a bear put spread to a favorable move in the stock, thus forcing you to wait longer before you can close the trade for your desired profit. Finally, bear call spreads still require buying power. The difference between your strikes minus the credit you receive will be locked out of your account. Still, for the hedge- or short-minded investor, bear call spreads have merits.

Bearish Calendar Spreads

Calendar spreads are also called “time spreads,” because you’re using different expiration dates on your two trades. Selling a near-term put (expiring in a few months) and buying a longer-term one (expiring at least a few months later), both with same strike price, sets up a bearish put calendar spread. The idea is the near-term put that you write will lose value more rapidly than the longer-term put that you buy and finance the purchase of your put, especially if you’re able to write near-term puts a few times while waiting for your longer-term puts to pay off. But this strategy comes with a caveat.

You’re generally hoping that the stock or index holds up long enough for your written puts to expire and then declines, making your purchased puts profitable. In other words, you’re bearish, but you want some time before prices decline — so perhaps you see a catalyst for decline on the distant horizon. That said, if the underlying investment falls rapidly, your long-term puts will have more value than the ones you wrote, and you could close both for a net profit.

Bearish calendar spreads using puts can be set up for very little cost. Your expectation should be that most times, you’ll lose your entire investment, but when it does work out, it will more than compensate for every loss. If your net cost for a put is $0.50, when the stock falls sharply, your profits will soar.

Bearish Calendar Spread (using puts)
Action: Write (“sell to open”) puts expiring soon, and buy (“buy to open”) the same strike puts expiring much later.
Trade type: Net debit. You pay to set up the trade.
Maximum loss: Your net debit.
Maximum profit: Once your written puts expire, your potential profit on the puts you bought is unlimited, until the stock goes to zero.
Break-even price: N/A.

Building upon what you’ve learned, a calendar spread that uses the same strike prices and different expiration dates is called a horizontal spread. One that uses different strike prices and different expiration dates is called a diagonal spread. For example, you might write near-term puts at a higher strike for a larger payment and buy long-term puts at a lower strike to set up a diagonal bear put calendar spread. (Yes, it’s a mouthful!)

Follow-Up on Your Trades

You usually want to close the vulnerable leg of your spread soon before expiration to avoid it being exercised. Furthermore, if the underlying stock makes a dramatic move that makes one side of your trade especially profitable (generally, the written side), you can consider closing it early and writing new options at a more advantageous price for another payment. A dramatic move that earns you much of your spread’s potential profit long before expiration may merit closing the trade out entirely, although in many cases you’ll need to wait until right before expiration to achieve your maximum profit. A dramatic move against you may severely limit your potential responses, other than to salvage what value still remains.

There are many other follow-up possibilities with spreads — including turning them into entirely different option strategies.

Bearish Spread Tips

  • In general, the best bearish spreads are initiated when the underlying stock is closer to the lower strike price rather than the higher one.
  • As you consider spreads, remember the general rule of options investing: Sell time value, and buy intrinsic value (this suggests, for instance, that a bear call spread that pays a large credit is not the best use of the strategy when the credit involves selling intrinsic value).
  • If you’re strongly bearish, but still risk averse, bear put spreads are best.
  • If you’re moderately bearish, or just don’t believe a stock will increase above your lower strike, then out-of-the money bear call spreads may suit you.
  • If you’re looking for a home run on an eventual sharp drop, a bearish calendar spread may be your ticket.
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