The Bear Put Spread

The Bear Put Spread is set up by buying a Higher strike Put while simultaneously selling a LOWER strike Put, both with the SAME expiration date.  The Bear Put Spread is a Debit Spread, meaning you will pay a higher price for the Put that you purchase than the price of the Put that you sell.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.

 

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).

What does it mean when someone shorts a stock?

If someone buys a stock, they are long the stock.  People do this, with the intention of selling it later for a profit (or collecting dividends, while they own it). 

If you have the correct account with a broker and have the required margin, you can also sell the stock first.  This is called being SHORT the stock or shorting a stock.  People do this with the intention of buying it back later at a lower price for a profit.  If someone wants to short a stock, they are supposed to borrow the stock from somewhere and then sell it (the broker will take care of this).  Then if the stock price goes down, they can buy it for less, making a profit.  If, however, the stock price rises, they will incur a loss when they purchase it at a higher price than they sold it.  In the recent past, there are the indications that the regulators have allowed people to just sell stock short, without borrowing it first.  This distorts the market. 

Let’s use the same Apple stock from February 6th to illustrate an example.  The following graph shows the risk/reward for shorting a stock.

 

Apple as of February 6, 2009

As you can see, at any price lower than the purchase price of $99.72 (the closing price on February 6, 2009), you will have a gain.  At any price above $99.72, you will have incur a loss, and at $99.72 this will be an even trade.

Notice that this is exactly opposite owning the stock, or being long.  The risk/reward graphs that I will continue to use, will be very similar.  They will show the risk/reward for any position, and if you “mirror” the graph around the $0 line (the x-axis in my graphs) they will show the risk/reward for the opposite position.

Please also notice that these two positions (being long or short a stock) have a possible unlimited gain and a possible unlimited loss outcomes.  Proper use of options will allow us to limit these (especially the losses).  For clarification, I say that owning a stock has a possible unlimited loss outcome, but in reality the stock can ONLY go to $0 (everyone remember Enron).  So really the most someone can lose when they buy a stock, is the purchase price.  Also, the maximum gain for being short a stock will occur if the stock goes to $0.

I have simplified this example, please remember that some stocks will have a dividend, stock splits, etc. that will affect this calculation.  For example, if you were to receive a dividend, it could be argued that this reduces your cost.  Please also remember that time value can be a factor in the calculation.

What are the possibilities when I own an asset?

When I own an asset, it is also known as being LONG an asset.  If I buy a stock, I am long the stock.  Assets can take many forms, a few examples are stocks, bonds, real estate, commodities, automobiles, etc.

When you purchase an asset, there are three possibilities that can happen in the future.
1. The asset can appreciate, meaning you will be able to sell it for more than you purchased it. This will result in a gain, and depending on the type of account it is held in, you may owe taxes on the gain.  These are the assets that we want to own.
2. The asset can retain its value, it neither appreciates nor depreciates. You will be able to sell this asset in the future for the same amount that you paid for it.
3. The asset can depreciate, meaning that when you sell it in the future, you will sell it for less than what you paid for it.  This will result in a loss, and depending on the type of account it is is held in, you may have a loss to claim on taxes.  Who would purchase an asset that depreciates?  Every adult that I know owns at least one depreciating asset……their car.

This is a risk/return graph for the owning an asset, I will use Apple on February 6, 2009 for this example.

 

Apple as of Februart 6, 2009

As you can see, at any price lower than the purchase price of $99.72 (the closing price on February 6, 2009), you will incur a loss.  At any price above $99.72, you will have a gain, and at $99.72 this will be an even trade.

I have simplified this example, please remember that some stocks will have a dividend, stock splits, etc. that will affect this calculation.  For example, if you were to receive a dividend, it could be argued that this reduces your cost.  Please also remember that time value can be a factor in the calculation.