Part 5 – Limited Risk Short Selling Strategy
Options afford traders the opportunity to achieve their objectives and/or trades in the market in ways that they might not otherwise be available able to them, while limiting risks, particularly in volatile markets.
We will discuss in this article the situation where an investor is bearish on a particular stock or index. One of their choices is to sell short shares of the stock. While this is a perfectly viable investment alternative, it does have some negatives including the fairly sizable capital requirements (and commissions) and that then there is technically unlimited risk, with no limit to how far the stock price could rise after the investor sold short the shares, e.g. in the case of surprise takeover bid.
Bear Put Spread Strategy – is designed to allow the trader to short sell a stock with limited risk.
The ability to short stocks in a highly volatile market with limited risk!! – sounds too good to be true! However that is precisely why traders use the Bear Put Spread Strategy, as it is an options trading strategy that is designed to allow the trader to take a short position in a stock, while limiting the risk. The payoff for the limited risk is limited profit potential, as we will discuss below.
The Bear Put Spread Strategy can be used to profit when a share price falls. The strategy is as an alternative to shorting a stock and is achieved through the purchase a put option and simultaneously selling the same number of put options with the same expiry date at a lower strike price. The maximum profit to be gained using this strategy is equal to the difference between the two strike prices, minus the net cost of the options spread.
Buying the put 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 unlimited profit potential (profit potential is limited only by the fact that a stock can only go to zero).
However despite these advantages, buying a put option that is not always the best alternative for a bearish trader particularly in these days of hyper volatility, which leads to higher premiums and more costly options. That is why the trader then simultaneously sells the same number of put options with the same expiry date at a lower strike price. Thereby reducing the cost of the trade to the difference between the option premiums, but also limited the profit to the difference in the strike prices of the bought and sold puts, less the premium initially received.
Advantages and Disadvantages
The Bear Put Spread Strategy has its advantages as it can lower your break even price by reducing the cost of the position and limiting the risk if the stock price surges higher for some reason, e.g. in the case of a takeover bid. However it has the disadvantage of cutting profits to the difference in the strike prices of the bought and sold puts, less the premium initially paid.
Sample Trade – Macquarie Bank (MQG)
Macquarie Bank (MQG) has been in a sustained downtrend since September 2009, as shown in Chart 1 below. However at the start of September this year we thought that the share price of MQG would fall further, given that their overseas peers globally have been leading the current share market selloff due the eurozone debt crisis.
Chart 1: Macquarie Share Price at time of trade entry
There have been rumors the Macquarie Bank is a potential takeover target, especially considering they were trading at a yield of 8% an PE of 8 and they had fallen 50% since the 2009 peak. Even though we thought the likelihood of a takeover in this current macro environment was highly unlikely, but we wanted to short MQG stock but limit our risk, so we opened a Bear Put Spread. Technical analysis was used to decide on the levels of option strike price that we would select, refer to Chart 3 below and note last month’s low was $21.25.
The Bear Put Spread trade for MQG was priced at 2 Sep’11 when the October options had 55 days until expiry and MQG shares were trading at $25.10. The trade was established by buying 1 contract of 2300 Oct11 put option (for $0.79/contract) and then simultaneously writing (selling) 1 of the 2150 OCT11 out of the money (OTM) put option (at $0.39/contract). This trade costs 40 cents/contract to place and would achieve a maximum profit of $1.10/contract. Note cost calculations do not include associated transaction costs. You can plan your trade using Market Analyser (see below).
Trade Note
You can plan and analyse your trade as shown above, using the Derivative Profiler option in the Market Analyser software.
Market Analyser also provides a payoff diagram for further trade analysis as follows:
Chart 2: The Bear Put Spread Trade Payoff diagram
This Bear Put Spread strategy is currently working as seen in Chart 3 below. This strategy reaches its maximum profit potential when stock price is equal to or greater than the strike price of the sold out of the money (OTM) options.
Chart 3: Macquarie Trade Current position
The goal of the Macquarie Bank trade is for the stock to be trade below $21.50, so the position is closed for maximum profit of $1.10/contract (refer to the payoff diagram above). Using the Bear Put Spread Strategy, the stock needs only move down by $0.40 (the cost of the trade) to reach break even, however the stock could surge higher, then the loss will be limited to the initial cost of the trade.
Conclusion
Options can be used in order to reduce your risk while still participating in potential profits from a significant move by the underlying stock. We have explained the Bear Put Spread strategy which allows you to take a short position in a stock with limited risk, however your profits to the downside will be restricted to the level of the short put strike.
The bear put spread offers an outstanding alternative to selling short stock or buying put options outright when a trader or investor wants to speculate on lower prices, but does not want to commit a great deal of capital to the trade and/or does not necessarily expect a massive decline in price. In either of these cases, the trader may give themselves an advantage by trading a bear put spread, rather than simply buying a naked put option.
In future articles we will talk about the High Yield Covered Put strategy which is particularly relevant to this market and the High Yield Covered Call strategy.
Utilise the features in the Market Analyser software to trade plan your options trades for the particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.
By Michael Hevern
Investment Advisor
See Also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2):The Covered Call
Options Trading for All Types of Market Environments (Part 3):The Covered Call Collar
Options Trading for All Types of Market Environments (Part 4):The Stock Repair Strategy
For Buy and Sell recommendations on ASX listed companies register for a free trial of MDS Financial Research.
MDS Financial Advisory Services offers general advice on trading options to generate consistent steady income on your investment portfolio. Call 1300 610 024 for further information.
