Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Last week, we started a new Real-World Trading series to discuss the details of a bear put spread. This week, we will delve further into the strategy and also choose a stock to follow using this strategy. The purpose of these articles is to show our readers how to find and use a bear put spread to profit when a move lower is expected for the underlying security.

There are several choices we have when we expect a stock to lose ground. First, we can sell the stock short, but this requires a lot of margin and has a number of rules that make it difficult. Second, we could buy a put and profit as the stock falls and our put moves further into the money. This is often a good strategy, but the entire amount we pay for the put is at risk and if the stock doesn’t move or moves against us, our max risk will be reached. Our third option is to use a bear put spread, which limits our risk, but, at the same time, limits our reward.

We should be setting an exit point for our trades before we ever enter a position and many of us are content to get out of a trade after it has doubled or tripled in value. This being the case, we can lower our up front cost and protect ourselves more by entering a spread. By selling an OTM put and buying an ITM or ATM put, we can still make substantial profits without the same risk as buying a straight put.

In order to further dissect this strategy, let’s enter a mock trade using a bear put spread and see how it works.

There are numerous ways to find bearish trades, but I used a program called Advanced Get to find a list of bearish candidates. I then looked at this list of stocks, trying to find the ones that are breaking through ascending trendlines. One stock that fits this criterion is Cigna (CI).

Cigna not only is breaking below its ascending trendline, MACD has also crossed over and the stock is breaking below its 200-day moving average support. 

Figure 1: Chart of CI with Technicals

The next thing we need to do once we find a stock that looks good technically is to check the news. The stock experienced a sharp decline on Tuesday due to a downgrade by an analyst at UBS Warburg. The company announced earnings back on May 2, so we don’t need to be concerned with an earnings announcement in the near-term. After we have established that there isn’t any pending news to impact our possible trade, we then need to look at the options.

The implied volatility for options out 90 days or more is still below the average for the last 12-months, but is rising. Though low IV isn’t as important with a spread as it is with a straight put, we still would like to see rising IV while holding the spread. Though we could enter any strikes, bear put spreads normally consist of a sold OTM option and a purchased ATM option. We also need to give ourselves at least 60-90 days of time. With Cigna, the next month available after July is October, so we will look at these options. The price for an Oct 50 put is $4.40; with an Oct 40 put selling for $1.20. This means that our total debit using these options would be $3.20.

Remember, we want to see at least a 2-to-1 reward-to-risk ratio. This is available with this trade and is figured this way. First, we take the difference between strikes, which is 10 points. We then minus out the debit of 3.20, leaving us with 6.80. This means our reward-to-risk is more than 2-to-1. 

Below is the risk graph for this trade:

Figure 2: Risk Graph for CI Bear Put Spread

Our breakeven point at expiration would be $46.80, which is figured by taking the net debit of 3.20 and subtracting it from the higher strike price of 50. The nice thing about a spread is the limited risk. Notice on the chart above how the trade loses very little money before expiration, giving us the ability to get out for a small loss if the trade moves against us. The trade off is that if the stock falls sharply, we don’t see as quick as profits as we would with a straight put purchase. Trading is full of trade offs, with each trader needing to find what works best for their own risk tolerance.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jody's Forum

 To read Part I of this series, please click here.

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• December 1, 2008
  Economic Watchdog, December 1
• December 1, 2008
  Morning Watch, December 1
• November 28, 2008
  Closing Wrap-Up, November 28
• November 26, 2008
  Closing Wrap-Up, November 26
• November 26, 2008
  Economic Watchdog, November 26