Choosing the “Right” Strategy—The Bear Put Spread
June 21, 2002
In previous articles in this series we have investigated a couple of bullish trades (the Bull Call Spread and the Bull Put Spread) and a trade that is based on the stock not moving (the Calendar Spread). We will look at a bearish trade in this article, the Bear Put Spread.
As the name implies, a Bear Put Spread consists of Puts and is used when the trader is bearish on a stock (expecting it to lose value). We normally expect our stocks to increase in value, not decrease, and so the Bear Put Spread is not a normal part of most investors’ arsenal; it is not a “natural” trade. After all, one must of necessity be an optimist when trading, as the majority of stocks tend to increase in value as time marches on.
So, why should we be concerned with a Bear Put Spread? First, not all stocks go up, and hence there is a segment of potential profits in the market that will be lost to any trader that does not have a bearish trade in their arsenal. Second, there are times when almost everything seems to be heading south, and hence a trader cannot find any trades if they are not playing them to the down side. Third, there are times when even if we are neutral or even slightly bullish on a stock, the returns from a Bear Put Spread will be attractive. Finally, as a method of diversification we might want to use a low-cost Bear Put Spread as protection against other more bullish positions we might have on a particular stock.
CONSTRUCTION
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 our account to enter the trade), and this debit will be the maximum loss that we can incur in the trade. At first glance this may appear to be a case of “buying high and selling low.” However, since the Put actually increases in value as the stock price drops, we are creating a trade where we are 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. Thus we want to put the trade on with less than 45 to 60 days before expiration. In addition, we want a stock that has some further room to fall, not one that is bouncing up against a $0.00 price, and hence we would generally want a stock with a current price of at least $15 to $20, the higher the better.
The risk graph on the Bear Put Spread at expiration looks like the graph below:
Figure 1: Risk Curve of Bear Put Spread
KEY:
A. Maximum profit of the trade (at expiration). The calculation is 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]}.
B. Maximum loss of the trade (at expiration). It 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]}.
C. Maximum price of the underlying at which the maximum profit is earned (at expiration). This occurs at the strike price of the short Put.
D. Break-even point of the trade (at expiration). As the price of the underlying rises above this level, the trade becomes more and more negative, until reaching the maximum loss of the trade at the strike price of the long Put. The Break-even is calculated as: {[the strike price of the long Put] less [the net debit of the trade]}.
E. The price of the underlying above which the maximum loss is incurred (at expiration). This occurs at the strike price of the long Put.
EXAMPLE
If we are looking for a bearish trade, we first need a stock that we believe will actually lose value over the next period of time. Of course, the best place to look for downward-trending stocks that we think will continue in such a direction is amongst 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 Corporation (IDPH). On Thursday, June 20, the stock closed at $33.98, down almost 50% over the past three months. Looking at the stock’s price and volume chart, (Figure 2.) we see it has a nice strong downward trend on increasing volume. As the stock is trading at $34 per share, there is certainly room for the stock to have a further downward move. IDPH is a company “engaged primarily in the research, development, manufacture and commercialization of targeted therapies for the treatment of cancer and autoimmune and inflammatory diseases.” They have a joint business arrangement with Genentech, Inc. (DNA), among other ventures. Sales were $79.7 million for the quarter ended 3/31/02, and net income was almost $30 million in the same time period. This is not a fly-by-night drug company, but rather one that is small, dependent on only two drugs, and is being pulled down with the general market meltdown in the drug industry.
Figure 2: Price and Volume Chart, IDPH, 6/20/02.
After deciding that this is a good candidate for a Bear Put Spread, we then must estimate how far down the stock is likely to fall in the next 30-60 days. This will determine just which Bear Put Spread (or spreads) we might look at. If we believe IDPH can easily fall to $25 by July’s expiration, then we can look at the options that are available to us for a Bear Put Spread. From the CBOE web site, the options and their associated prices are given below in Table 1.
OPTION | BID | ASK |
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 |
Table 1: Selected options and their related Bid/Ask prices from the CBOE website for IDPH on 6/20/02.
From these options we can actually construct six Bear Put Spreads. Arranging the various Bear Put Spreads in descending order of breakeven (one measure of increasing risk), we get Table 2.
BEAR PUT SPREAD | DEBIT | MAX PROFIT | % RETURN | BREAKEVEN |
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 |
Table 2: Analysis of Various Bear Put Spread choices for IDPH.
Looking at our choices, we must now select one to trade. If we are very conservative, we would choose the July 40/35 Put spread, where we 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 us a 32% maximum profit, which comes if the stock closes at or below $35 on July 19, 2002. As the stock is presently selling just under $34 per share, we are already at the maximum profit point. In fact, the stock could actually increase by $1 and we would still garner the maximum profit on this trade! To simply breakeven on the trade, the underlying stock could increase almost $2.25 (7%) and we would still be profitable.
On the other hand, if we wanted to really swing for the fences, if we were willing to take the most risk, we would 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 IDPH were to fall below $25 by July 19, 2002. 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, must fall over $5 just to break even. Of course, the other four trades fall somewhere in between these two extremes.
Which trade should we choose? Depending on our belief in the weakness of the stock price and our tolerance for risk, we could choose the Jul 30/25 Bear Put Spread, and pull in a spectacular 335% return in just one month if we are correct in how far and how fast IDPH 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 we would still get the maximum return (32%) on the trade! If we could do this every month, 32% compounded monthly would result in an original $3,800 (10 original contracts) growing to more than $10,600 dollars. Of course, this does not take into account commissions and taxes, but even so, the returns would sure beat the average (or even above-average) mutual fund.
Given the spectacular returns possible with even the most conservative of the choices, lets look at what the risk curve of that Bear Put Spread would look like—the 02 Jul 40/35 Bear Put Spread risk curve is shown below in Figure 3. For this example, we will use 10 contracts, or a maximum debit of $3,800.
Figure 3: Risk curve of 10 IDPH Bear Put Spreads
KEY:
A. Maximum profit: [{(40-35) – (3.80)} x (100) x (10)}] = $1,200
B. Maximum loss: [(3.80) x (100) x (10)] = $3,800 = debit of trade
C. Underlying price at maximum profit: $35 or less (at or below the strike price of the short Put)
D. Breakeven: [(40) – (3.80)] = $36.20
E. Underlying price at maximum loss: $40 or more (at or above the strike price of the long Put)
EXIT CRITERIA
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 our advantage. If the stock moves sharply against us, especially early on in the trade, we 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:
1. If the stock moves sharply one direction or the other early in the trade:
A. 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 – 80% of your expected profit. In this trade, you would be looking to make approximately $0.85 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.}
B. 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.
2. As you approach expiration day,
A. 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.
B. If the stock is between the short and the long Puts, you must make a decision as to 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 breakeven price, you will make a profit. As the stock price closes above the breakeven, 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.
C. 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,
i. Let both options expire worthless, taking the full loss of the debit.
ii. 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.
iii. Exit the entire position, selling the long Put and buying back the short Put.
iv. Morphing 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, your outlook for the stock has switched from bearish to bullish and there is still some time left (several days to a week) prior to expiration.
OUTLOOK FOR THE UNDERLYING
Bearish Outlook: As the name implies, the Bear Put Spread is a bearish trade. This trade works best in a short time frame, as stocks will tend to go down faster, but over a shorter time frame, than they will go up.
Neutral Outlook: As was seen in this example, the Bear Put Spread can work very well if we even have a basically neutral position. The key here is to look for the right combination of strikes and premiums such that our returns are acceptable for the risks we are taking.
Bullish Outlook: If we have a bullish outlook for the stock, this type of trade really doesn’t work very well. As the potential returns are not as great as with a Bull Call (or Put) Spread, there isn’t as much room for the stock to move in a direction opposite the natural direction of the trade.
THE GREEKS
Similar to the Bull Call Spread, the Bear Put Spread tends to minimize the affects of the Greeks on the trade. Because we 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, one gets a net Delta of –24.625: not exactly Delta Neutral, but 2/3’s closer than if one simply purchased the Put.
Theta (Time decay): Time decay is both working against us (the long Put) and for us (the short Put). The resulting combination will depend on just which options we buy and which options we 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 we are buying a slightly ITM Put and selling one that is close to ATM, time value will actually be working just slightly in our favor in this particular example. However, a different selection (the 02 Jul 30/25 Bear Put Spread, for instance) would have time value working slightly against us.
Vega (Volatility): Like with Theta, we are both buying and selling volatility. Unless there is a significant skew around the monthly options, we will be buying and selling approximately 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 our position will not bounce all over the map with every price change of the stock. This will help in our 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, we need to hold the position until it gets close to expiration, or the stock must move really significantly for us to prosper.
ADVANCED TECHNIQUES
A trader can improve the probability of success of a Bear Put Spread by looking for firms that are in industries that are already in trouble. 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. Since 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 Optionetics.com, among other places.
CONCLUSION
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.
Good Trading.
Andrew Neyens
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
aneyens@optionetics.com
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