Options afford traders the opportunity to achieve their objectives and/or trades in the market in ways that might not otherwise be available able to them, while limiting risks, particularly in volatile markets.
Today we’ll discuss a situation in which an investor is bearish on a particular stock or index, but wants to hedge their short position. 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). 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 a surprise takeover bid. To hedge the risk of being stopped out in the near-term, buy a call option above the market.
Also see A Limited Risk Short Selling Strategy.
Hedged 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 Hedged 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 Hedged 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, while hedging with an out of the money call. The maximum profit to be gained using this strategy is equal to the difference between the two strike prices (and any money made on the call options), minus the net cost of the options spread and calls.
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). The position is hedged by buying the out of the money calls to benefit if the stock surges in the near-term, prior to its sell-off. Note this does add to the cost of the trade.
However despite these advantages, buying a put option is not always the best alternative for a bearish trader, particularly in 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. This reduces the cost of the trade to the difference between the option premiums, but also limits the profit to the difference in the strike prices of the bought and sold puts, less the premium initially received. The position is hedged by buying the out of the money calls.
Advantages and Disadvantages
The Hedged 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. The position is hedged by buying the out of the money calls to benefit if the stock surges in the near-term, however this does add to the cost of the trade.
Sample Trade – Origin (ORG)
Origin Energy (ORG) is an Australasian integrated energy company focusing on energy markets in Australia and New Zealand. ORG had been in a steady uptrend for the last month as it has risen from $10 to $13 and we were of the view that the $13 – $13.20 area would offer resistance as it had done for the past 12 months. It had been unable to close above $13, suggesting a loss in momentum near-term.
The current uptrend in ORG has been relatively steady without many dips so even if ORG were to retrace we expected it to head down towards $12.25. So with a strong resistance area just above the current price of ORG we suggested a short position with a hedge to profit if ORG surged through the near-term resistance level.
Using options you can enter into a hedged PUT spread. BUY the APR13 1275/1225 PUT spread for 8c, and hedge the position with a MAR 1325 CALL.
Chart 1: Origin Share Price at time of trade entry
The Hedged Bear Put Spread Strategy for Origin (ORG) was recommended at 15 February 2013 when the April options had 55 days until expiry and ORG shares were trading at $13.03. The trade was established by buying 1 contract of ORG April 1275 PUTs @ 19c and then simultaneously writing (selling) 1 of the out of the money (OTM) put option ORG April 1225 PUTs @ 8.5.
We then purchased the out of the money (OTM) call option ORG March 1325 Calls @ 8.5c. This trade costs 19 cents/contract to place and would achieve a maximum profit of $0.31/contract if the stock sells-off sharply, but we had the added sweetener that we had a hedge on the upside above $13.25 at March expiry. Note cost calculations do not include associated transaction costs. You can plan your trade using IRESS Trader.
The Hedged Bear Put Spread Strategy Payoff
For maximum profit we wanted Origin to surge if it broke through its overhead resistance, and then sell off after March expiry. The payoff diagram is a little complicated, see below.
Payoff diagram at March Expiry. Note there was still another month until April expiry for the PUT Spread.
Trade Note
This Hedged Bear Put Spread Strategy worked a treat, with the $13.25 March calls expiring at around 30c/contract, a profit with Origin closing at $13.57 and we still had a “free” Put Spread. This Bear Put Spread trade can now be at close to its maximum profit potential, currently valued at 47c/contract with Origin trading at $11.83 on 19 April.
So for an initial outlay of 19c we were able to profit around 300% on the trade.
Chart 3: The Origin Trade at the close of the trade
The Trade
The Origin trade worked perfectly with the OTM call expiring in the money and the subsequent stock sell-off allowed us to profit from the bear put spread as well. The Hedged Bear Put Spread Strategy strategy offered a perfect vehicle for trading the Origin stock as it allowed us to avoid being stopped out on the short position when the stock broke above resistance, while still participating in the eventual sell-off.
Conclusion
Options can be used to reduce your risk while still participating in potential profits from a significant move by the underlying stock. We have explained the Hedged 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 and if the stock surges and breaks overhead resistance in the near-term then your trade can also profit.
The Hedged Bear Put Spread Strategy with a hedge 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 with a hedge, rather than simply buying a naked put option.
Utilise the features in the IRESS Trader 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.
For more trade ideas and recommendations on how to trade in this market, sign up for a free trial of the D2MX Daily Trading Report, which provides a daily serving of insightful market analysis and trade recommendations from the D2MX Advisory team, including:
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To request an obligation-free trial, call 1300 610 024, email advisory@d2mx.com.au or register online at www.d2mx.com.au.
Michael Hevern
Investment Adviser – D2MX Advisory
See Also:
Options Trading for All Types of Market Environments
Part 1: The Protective Put
Part 2: The Covered Call
Part 3: The Covered Call Collar
Part 4: The Stock Repair Strategy
Part 5: Limited Risk Short Selling Strategy
Part 7: Dividend Capture Covered Call Collar
Part 8: Hedging With a Bear Put Spread
Part 9: The Bull Call Strategy
Part 10: Dividend Capture Covered Call Collar
Part 11: Calendar Call Strategy
Part 12: Bull Call Spread Strategy
Part 13: Reverse Calendar Call Strategy
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.
