A Roaring Alternative to Short Selling
02/28/2013 8:00 am EST
When markets are tanking and a trader wants to speculate on lower prices, but doesn’t anticipate a massive decline nor want to commit a lot of capital, the staff at Investopedia.com suggest an alternative to outright short selling or plain buying put options.
Two of the best features of options are that they afford an investor or trader the opportunity to achieve certain objectives and/or play the market in certain ways that they might not otherwise be able to. For example, if an investor is bearish on a particular stock or index, one of the choices is to sell short shares of the stock. While this is a perfectly viable investment alternative, it does have some negatives. First off, there are fairly sizable capital requirements. Secondly, there is technically unlimited risk, because there is no limit as to how far the stock could rise in price after the investor sold short the shares. Fortunately, options offer alternatives to this scenario.
The Put Option
One alternative to shorting a stock is to purchase a put option, which gives the buyer the option, but not the obligation, to sell short 100 shares of the underlying stock at a specific price—known as the strike price—up until a specific date in the future (known as the expiration date). To purchase a put option, the investor pays a premium to the option seller. This is the entire amount of risk associated with this trade. The bottom line is that the buyer of a put option has limited risk and essentially an unlimited profit potential (profit potential is limited only by the fact that a stock can only go to zero). Nevertheless, despite these advantages, buying a put option is not always the best alternative for a bearish trader or investor who desires limited risk and minimal capital requirements.
Mechanics of the Bear Put Spread
One of the most common alternatives to buying a put option is a strategy known as a bear put spread. This strategy involves buying one put option with a higher strike price and simultaneously selling the same number of put options at a lower strike price. As an example, consider the possibility of buying a put option with a strike price of $50 on a stock trading at $51 a share.
Let's assume that there are 60 days left until option expiration and that the price of the 50 strike price put option is $2.50. In order to purchase this option, a trader would pay a premium of $250. Then, for the next 60 days he or she would have the right to sell short 100 shares of the underlying stock at a price of $50 a share. So, if the price of the stock fell to $45, $40, $30 or even lower, the buyer of the put option could exercise his or her put option and sell short 100 shares at $50 a share. He or she could then buy back the shares at the current price and pocket the difference between $50 a share and the price he paid to buy back the shares.
The other, more common, alternative would be to sell the put option itself and pocket the profit. For example, if the stock fell to $40 a share, the buyer who bought the 50 put option at $2.50 would be able to sell the put option for $10 or more, resulting in a substantial profit.
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Advantages of the Bear Put Spread Alternative
The problem with buying or selling a put option is that the breakeven price for the trade in the example above is $47.50 per share, which is calculated by subtracting the put premium paid ($2.50) from the strike price ($50). To look at it another way, the stock must decline. Also, a trader may not be looking for a substantial decline in the price of the stock, but rather something more modest.
In this case, an individual might consider the bear put spread as an alternative. Building on the same example, an individual may buy the same 50 strike price put option for $2.50 but will also simultaneously sell the 45 strike price put option and receive $1.10 of premium. As a result, the trader only pays a net cost of $140 to purchase the spread ($2.50 - $1.40 x 100 shares). There are two positives and one negative associated with this alternative compared to simply buying the 50 strike price put for $250.
Advantage No.1: The trader has reduced the cost of the trade by 44% (from $250 to $140).
Advantage No.2: The breakeven price rises from $47.50 for the long put trade to $48.60 for the bear put spread (the breakeven price for the put spread is arrived at by subtracting the price of the spread ($1.40) from the higher strike price ($50 - $1.40 = 48.60).
As a result of entering the bear put spread, this trader has less dollar risk and a higher probability of profit. If the trader does not expect the price of the stock to decline much below 45 by option expiration, this may be an outstanding alternative.
Disadvantage of the Bear Put Spread
There is one important negative associated with this trade compared to the long put trade: the bear put trade has a limited profit potential. The potential is limited to the difference between the two strikes minus the price paid to purchase the spread.
In this case, the maximum profit potential is $360 (5-point spread - 1.40 points paid = $3.60). This trade will show a profit at option expiration if the stock is at any price below the breakeven price of $48.60 a share. The maximum profit of $360 will be reached if the stock is at or below the lower strike price of $45 a share at expiration. While the profit potential is not unlimited, the trader still has the potential to make a profit of 257% ($360 profit on a $140 investment) if the stock declines roughly 12% (from $51 to $45).
The Bottom Line
The bear put spread offers an outstanding alternative to selling short stock or buying put options in those instances when a trader or investor wants to speculate on lower prices, but does not want to commit a great deal of capital to a trade and/or does not necessarily expect a massive decline in price.
In either of these cases, a trader may give himself or herself an advantage by trading a bear put spread, rather than simply buying a naked put option.
By the Staff of Investopedia.com