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Options Lab Part 4: Savvy Strategies to Hug a Bear

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December 1, 2013

You’ve probably noticed that the market doesn’t go up all the time. I know, thank you, Captain Obvious. There’s always the chance that the market might drop, and often, a downtrend can stretch on for an uncomfortable length of time.

During downtrends, the average stock investor does one of two things: he watches his portfolio lose value and hopes that the market will eventually turn back around, or he takes his money out of the market and hopes that the market doesn’t turn around right away. Both tactics are emotionally painful. More importantly, they are reactive. Now a more sophisticated stock trader may decide to take an aggressive route and sell stock short. This strategy may help a trader profit if the market continues to drop, but due to the unlimited risk of the strategy, it may also bring on significant losses fairly quickly should the market rally hard.

The good news is there are choices. Certain options strategies are proactive and may be appropriate for long, sustained bearish markets. They can also help limit bearish exposure should the market turn around. Let's start with the basics.

Keep It Simple: Buy A Put

The most basic bearish option strategy is the long put. A put option gives the holder the right to sell stock at a fixed price (the strike price) for a limited period of time. That means in order to make money via the purchase of a put option, you’re hoping the stock will drop below the fixed price at which you have the right to sell it. Remember, fees and other transaction costs will apply.

Let’s dig in to an example. Suppose you’re bearish on XYZ stock, currently trading at $55 per share. You think the stock may drop significantly, so you buy the XYZ May 50 put for $2. Now that you own the put option, you have the right to sell the stock at a price of $50 per share. Of course, with the stock currently at $55, you’re in no rush to exercise your right to sell stock at $50. Consider the $2 as the cost of your just-in-case protection.

Sounds Complicated. How Does It Make Money?

Good question. Remember that you bought the put, and as with all things that you buy, in order to turn a profit, you have to sell it for more than you paid for it, including the transaction costs (commissions and fees). Therefore, now that you own a put, you are looking for the following scenario to develop: First, since you want to sell your put option for more than you paid, you’re hoping that the value of the put goes UP. That means you also want the value of the stock to go down.

Still confused? Let’s go back to your purchase of the XYZ May 50 put for $2. If XYZ settles at expiration at $50 or higher, the May 50 put expires with no value and you lose $2, or $200 per contract (100 shares per contract) plus the transaction costs. But the beauty here is no matter how much higher than $50 per share XYZ settles ($55, $100, hey, even $1,000 per share), your loss is limited to what you paid for the put option. There is some comfort in knowing that no matter how wrong you are, there’s a limit to the financial pain.

Now here’s the even better part. If the stock drops below $50, you can buy the stock for less than $50, then sell it at $50 by exercising your put (breakeven on this trade is $48). That’ll make you some money, minus the cost of the transactions (commissions, contract fees, and the exercise fee).

As you can see, if the stock drops way below $50, say to $20 per share, then you can buy the stock at $22 including your put and sell it at $50 by exercising that put. The difference between those two prices is yours to keep. Believe it or not, the lower the stock drops, the more you stand to make via the purchase of your put option. Who knew bears could be so happy?

But, I Already Sold Stock Short

Selling stock short is considered an aggressive bearish strategy because theoretically, there is unlimited risk to the upside. Traders sell “short” because they’re guessing that they can buy back a stock they like at a cheaper price. If the stock rallies unexpectedly, you could lose big bucks. But since you went ahead and did it anyway, there’s still a way to keep your short stock and limit your upside risk. You might buy a call option to help protect the upside exposure of your short stock position.

Let’s suppose you sold 100 shares of XYZ stock short at $50 per share. Now, the higher XYZ moves above $50, the more money you stand to lose when you’re forced to buy back your short XYZ position. However, if you buy one XYZ May 50 call for, say, $4, you can still make money with your short stock position in case the stock drops. If the stock rises above $50 per share, your long $50 call would offset what you could lose in your short stock.

Today’s Take-Home: Just remember that the $4 you paid per share (plus transaction costs) is the maximum money you can afford to lose should you keep this position through expiration. The bigger question to ask: is that a price worth paying for some short-term protection?