REAL-WORLD TRADING: The Bear Put Spread, Part IV
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June 18, 2003
A bearish strategy has been a tough way to make money these past three months, with the bulls controlling the market place. However, our bear put spread on Cigna (CI) is working out, though at a slow pace. Since June 3, the S&P 500 ($SPX) is up 40 points, yet shares of Cigna have fallen about five percent. Though we would like to see a larger drop in the shares, it might be difficult without the help of the broader market. Below is the week-to-week data for this mock bear put spread trade:
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
6/17/2003
Cigna (CI) @ 48.64
1 Oct 50 Put @ 5.10 (bid) IV = 41.5
1 Oct 40 Put @ 1.60 (ask) IV = 46.5
Initial Debit = 3.20 or $320
Current Credit to close = 3.50
Profit = $0.30 or $30 per spread
This trade was looking really good on Monday when Cigna shares hit a low of $46 intraday. However, since that time, the stock has gained ground, closing Tuesday at $48.64. However, Cigna moved below its 200-day moving average this past week and this area might now become resistance near $48.50.
With any trade, it is important that we understand the risks and have an exit plan in place. Below is the risk graph for CI through Tuesday.
Figure 1: Risk Graph of CI Bear Put Spread
As with any strategy, there is a tradeoff between reward and risk. Obviously, if CI shares were to fall sharply, we could make larger profits by owning a straight put. However, if the stock moves against us or doesn’t move lower, the overall risk is much lower with a spread. Though a large move in the underlying security can produce quick profits, a vertical spread is more of a longer-term strategy. This is because the lowered risk creates a situation where the trade has difficulty seeing large gains until expiration. Nonetheless, there are often times when a bear put spread will see a doubling of price, where the trader can then sell half of the contracts and hold on for further profits without any risk.
Though we have to wait for large profits using a bear put spread, we also can get out with small losses if the stock moves against us. For example, we might want to exit this trade if CI were to move above its recent high near $57.50. Depending on the time left in the trade, we could exit at this point for less than half the initial debit. Over the long haul, we profit trading options by letting our profits run and cutting our losses short. Our reward to risk ratio on this trade is slightly better than 2-to-1, which is about the lowest ratio we want to see for this type of trade.
So far, implied volatility hasn’t changed much for this trade. However, the purchased put has increased slightly more than the sold put, which is a positive sign. Looking at other data about Cigna, we see that the put/call ratio is extremely low. In fact, the average put/call ratio over the last six months is 1.007, with the currently ratio at 0.261. This says that there are an over abundance of calls being purchased compared to puts, which is a bearish sign for the stock. When bullishness becomes high, it is a contrarian indicator.
Even though the stock gained some ground the last few sessions, there isn’t any change in our belief the stock will go down. If the technicals change and we foresee that CI is not going to move lower, then we’ll close the trade. However, so far, things are working out despite a bullish stock market.
Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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