Category Archives: Bearish Option Strategies

Bear Call Spread

Bear Call Spread

The bear call spread is a vertical credit spread. With a vertical credit spread the investor will sell a lower priced strike call option and purchase a farther out of the money call option as insurance to limit risk. The credit received is the premium received for the short call minus the premium paid for the long call. The maximum risk is defined as the distance between the strikes selected minus the net premium received. The bear call spread is used when your forecast for the underlying is neutral to bearish. To obtain the maximum credit we want the underlying to stay below the short call so that both options expire worthless and we collect the credit. Let’s look at an actual example that currently has decent profit potential. On April 27th, 2012, Amazon, AMZN closed at $226.85. If we look at the weekly call options that expire on May 4th, the $230 call will sell for $2.80 and the $235 call can be bought for $1.44. The net credit we’ll receive is $1.36 or $136 per contract. If we set our maximum allowable loss at $5,000 we’d use 13 contracts. The actual maximum loss would be $4,732, the theoretical profit or expected return would be $1,453 and the maximum profit would be $1,768. If AMZN rises to the lower strike at $230 you could close out the position or do some dynamic delta adjusting to control loss. The position could be adjusted by adding some long calls, short puts or buying some AMZN stock or any combination of those.  The chart below shows the profit/loss points for this call spread.

Investors who have long term stock holdings may also want to use a bear call spread to produce income and have potential for upside gain. One of the disadvantages of the popular covered call strategy is that in exchange for the income received from the covered calls, the investor is forced to forgo upside gain. If the underlying fund makes a large upside move, the investor does not participate. With a bear call spread income is produced by selling out of the money calls and purchasing further out of the money calls in the same quantity.  This way in the event that the stock makes a large upside move, the investor will participate and still receive some income. For example if our investor owns 100 shares of ABC at $25, she could sell one $30 call and buy one $35 call for a net credit.  Above $30 the shares would get called away, but she would still own the $35 call.  Therefore, if the stock were to rise above $35 she would still have unlimited profit potential from the remaining long call at the 35 strike.

The Covered Put

The Covered Put

The covered call is probably the most popular option strategy used today. It is very simple. Most investors tend to be long stocks and the idea of writing a call option, collecting some premium and being willing to accept a higher price for your underlying equity position appeals to many investors. Covered calls can provide some decent income and limited downside protection while you are waiting for your stock to appreciate to your desired exit price.

The married put is similarly another simple option play that is very common. With a married put, the investor will purchase a stock or an ETF then buy a put for insurance to protect the downside. With a married put the risk is limited and the upside reward in theoretically unlimited.

The covered put is not commonly used at all, yet can be a good strategy. Most investors don’t short stocks, so it is not nearly as common as the two strategies mentioned above. The covered put is just about the opposite of the covered call. The investor will identify a stock or ETF that he thinks has topped out and believes that it’s time for a short position. The stock is sold short and then a put option is sold on that position at a price point that the investor will be happy to buy the stock back. The profits to the downside are limited to the strike price selected and the premium received for the sale of the put. Just like a covered call there is risk to adverse price movement in the underlying, but now it is to the upside.

So, if you think that ABC stock won’t go any higher, you could short ABC say at $25. Then you could sell a $20 put say for $1. If ABC goes below $20 you’ll get assigned, buy the stock back at $20 and close out your position for a $6 profit. The percent return that you’d receive depends on the margin rate that you get from your broker.

Shorting stocks isn’t for everybody, but the covered put can be a viable strategy. As always it’s wise to do some thorough research and avoid stocks that could be potential takeover candidates or that could experience rapid price appreciation for some other reason like a new product announcement, lawsuit getting settled etc. Investors who rely on technical analysis alone should review the fundamentals to see if there are issues like that pending that could impact the price.

Married Put P/L Graph

P/L Graph for a Married Put