While other stock investors fear bear markets, how would you like to be a “grave digger” and profit from the dark side?
By using options with a small percentage of your overall portfolio, you can construct bear put spread positions that profit from weaknesses in stocks. This allows you to enhance your over-all return, while smoothing out your portfolio’s equity swings.
Before we discuss the details, this caveat bears repeating: no matter how lucrative options appear, remember that they are a “swinging for the fences” type of play. You have to be right on both market direction and timing, so there is a very likely chance that you will “strike out” and lose your investment. But, when you are successful, you can make large percentage returns. You should limit options activity to 10% or less of your portfolio.
A bear put spread is an options position that is created by buying a put option on a stock that you think will decline, and then simultaneously selling short another put option on the same stock that has the same expiration, but a lower strike price.
The bear put spread has a higher chance of success than just buying a put option, because it reduces your purchase price. The trade-off is that if the stock really tanks before the options expire, and drops below the strike price of the short option, you will not make as much money as a simple long put position. In fact, the maximum profit on a bear put spread is equal to the difference in strikes. This maximum profit occurs when the stock price drops to the strike part of the short put.
Let’s look at an example:
Let us say that IBM stock is currently trading at $ 186 a share, and September 185 puts are trading at $ 1.55, and that September 180 puts are trading at 85 cents.
1. We simply buy (go long) a September 185 put – In this case, we pay $ 155 for the option (options are sold per 100 shares). If, on expiration, IBM is trading at $ 184, then our position is only worth $ 100. Even though IBM stock dropped, we lost $ 55 on our options position.
2. We set up a bear put spread by buying the September 185 put while selling the September 180 put – Now, we still pay $ 155 for the 185 put, but we take in $ 85 for selling the 180 put. So, our expense is only $ 70. If IBM is trading at $ 184 on expiration, our position is worth $ 100 (the 185 put is $ 1 per share in the money and the short 180 put expired worthless). Since we only paid $ 70, we have a 43% profit on the option when the underlying stock dropped by only 1.08%!
Again, the trade-off is that the maximum profit from the bear put spread is the difference between the strikes (185-180). So, the most we could make is $ 500. For example, if IBM had fallen to $ 179 by expiration, our long 185 put would be worth $ 600. But, under the bear put spread, we would have lost $ 100 on the short put. So, our profit stays at $ 500.
Praveen Puri has 20 years of trading and investment experience – including serving as a consultant to major insurance companies, banks, and the Chicago Board of Trade. He is the author of Stock Trading Riches, which details a mathematical stock trading method that isn’t exciting or “sexy”, but is extremely lucrative.