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Strategy Session: Bear Put Spread
Author: Price Headley (info)
Website: http://bigtrends.com
Posted: July 10th, 2007 at 5:25 pm EST
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A couple of weeks ago, we examined how a bull put spread was a nice way of lowering your cost basis on a straight call purchase, by selling a different call (same expiration, different strike) to offset some of the initial expense. Though there’s still a net debit, it will be lower. Thus, your total return (on a percentage basis) will be greater on the whole trade. Does selling a call against a call you own cap the upside potential? Yep, but that’s the nature of the beast….less risk, less reward. The trick is to find the optimal risk/reward balance that’s right for you. If you missed it the full explanation, click here to review it.
A bear put spread is basically an upside down bull call spread. The key difference, of course, is you’re expecting a stock to move downward (and not just neutral to bearish…..you want/need the stock to go lower). As usual, an example will clarify the concept.
Say you think Disney (DIS) is finally going lower, and you want to get a little more leverage on the downtrend than just shorting the stock would provide. With the current price at $34.52, you could just buy an in-the-money put option….perhaps the August 35.00 puts, at a price of $1.45 (or $145 per contract). If the stock fell all the way to $32.50, your puts would be intrinsically worth about $2.50, or $250 per contract (plus a little more, for ‘time value’). At that point, the $2.02 price decline in shares of DIS would mean about a 72% gain ($250 exit price less the $145 entry price = 72% gain).
Not bad, right? But, your total percentage return could be even better.
To lower your overall cost basis, and make the trade a bear out spread, you could short an out-of-the-money put with the same expiration month. In this case, probably the $32.50 puts make the most sense (we’ll see why in a second). You could sell/short these $32.50 puts for 35 cents, or $35 per contract. Thus, your net expense to take the entire trade would just be $110 per contract ($145 to buy the 35 puts, less the $35 in proceeds you get from selling the 32.50 puts). Disney’s move from $34.52 would then mean a ‘total’ trade gain of 127%….much better than the 72% gain on just the purchase of the 35 puts. Why? Your value on the 35 puts is still $250, but your NET cost basis is now only $110.
BUT (and isn’t there always one of these?), that’s also going to be the maximum gain here. If DIS falls to anything under $32.50, the puts you shorted are going to be exercised against you (probably), which you could offset by exercising the 35 puts you own. The net difference between those two is your maximum gain….$2.50, or $250 per contract. Conversely, just owning the 35 put without shorting the 32.50 put could theoretically mean near infinite gains.
So why bother? Like we said last time, this isn’t meant to be a home-run hitting strategy. Bear put spreads, like bull call spreads, have a primary intent to lower your cost basis. You still have to be right abut your directional call though.
Still doesn’t seem worth it? Here’s the attraction. Like we said with the bull call spread, it’s not easy to feel like you’re capping your gains. But, be honest - what are the odds DIS is really going to fall under 32.50 over the next seven weeks? It’s certainly possible, but is it likely? If you think it is, then yes, you’re correct….the bear put spread isn’t worth it. But, if you think a 5.7% decline in a blue-chip isn’t likely between now and mid-August, then the bear put spread is a way of getting a little more bang for your buck without necessarily giving up much (if anything).
Nuances: In general, it’s best to buy a put that’s barely in the money, and it’s best to short a put that’s not too far out of the money. Otherwise, it’s really not mathematically worth it. When there’s a $5 separation between strikes, this can be hard to do (or when the current stock price is at inconvenient levels between strikes). For that reason, you may find a little more flexibility using stocks with strike intervals of only $2.50.
By the way, thanks for all your feedback regarding these advanced option strategy ideas. We’re glad so many of you are able to consider them. One thing we really want to stress though (no matter where you are as a trader)…..PAPER TRADE THESE CONCEPTS! The best way to learn is by doing it, but there’s no need to risk real capital if you’re not comfortable with the strategy.
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