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This is the third article in our series on a bear put spread strategy. Last week, we went through the process of choosing a stock and then entered a mock trade on Cigna (CI). There were several reasons why we liked Cigna for a bear put spread. First, it had fallen below its ascending trendline and the stock came up as a Type One Sell on Advanced Get. Volume increased during the decline and MACD had turned bearish. Once we saw that Cigna was a good bearish candidate, we had to make sure implied volatility wasn’t too high and that the reward-to-risk ratio was appropriate for a bear put spread. These all checked out, so we entered a mock trade using the following data:

Bear Put Spread
6/3/2003
Cigna (CI) @ 51.36
Buy 1 Oct 50 Put @ 4.40  IV = 39
Sell 1 Oct 40 Put @ 1.20  IV = 46
Initial Debit = 3.20 or $320
Max Risk = $320
Max Reward = $680
Breakeven = 46.80

6/10/2003
Cigna (CI) @ 49.66
1 Oct 50 Put @ 4.60 (bid) IV = 41
1 Oct 40 Put @ 1.20 (ask) IV = 44
Initial Debit = 3.20 or $320
Current Credit to close = 3.40
Profit = $0.20

So far, the trade has worked out like we planned. The stock has fallen further, recently moving below its 200-day moving average, another bearish sign. Below is a daily chart of Cigna with various indicators attached.

Figure 1: Chart of CI with Technicals

One advantage to bear put spreads is the fact that a move higher doesn’t result in a large loss immediately. This is a way to hedge our risks as we can get out without much of a loss if the stock doesn’t act like we thought it would initially. At the same time, with less risk is less reward and a drop in the shares of Cigna won’t immediately create large profits. However, as expiration approaches, if the stock is trading below 50, the long option will keep value while the short option becomes worth less. At the same time, if the stock falls below $40, a nice profit can be achieved before expiration in October. In order to see what profits we can expect with a given move in the stock, we need to look at a risk graph.

Figure 2: Risk Graph for CI Bear Put Spread

If we look at the risk graph, we can figure where the stock has to be in order to achieve a particular profit objective. For example, if we want to double our money, we would need to make $320 in profits. By looking at the risk graph, this means the stock would have to be at about $43 with 86 days left to expiration. Of course, this is assuming that implied volatility stays constant. Each of the different colored lines tells us what our profits would be at a given stock price with a certain amount of time left until expiration.

Platinum also provides us with an idea of what profits (losses) would be achieved just from a change in implied volatility.

Figure 3: Implied Volatility Risk Graph for CI Bear Put Spread

Notice from the graph above that an increase in IV still benefits our trade even though it is a spread. A change in IV isn’t as great with a spread as it would be with a straight put, but it still plays a factor.

We can use these tools to figure an exit, both to the downside and the upside. For example, if we don’t watch our trades each trading day, we might have an alert sent to us if the stock reaches a predetermined price that correlates with an exit price. As a rule of thumb, we try to get a 100 percent return on our initial investment. At this point, we can close half the contracts and let the others ride for larger profits. Normally, once our total profit equals 80 percent of the max profit, we can then exit and move on to other trades. This is because we have to wait until expiration most the time to garner the last 20 percent of a trade and this isn’t time effective. These are just rules of thumb and don’t need to be followed. In fact, each trader often has their own exit rules and that is fine, just make sure you know them ahead of time and stick to them. I personally like to see what the trade is doing once my initial target is met. At this time, I will either exit or set a mental stop so that a winner doesn’t turn into a loser.  


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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