Chapter 19 - Bearish Option Strategies Flashcards
What is a bear call spread?
The strategy
A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B.
A short call spread is an alternative to the short call . In addition to selling a call with strike A, you’re buying the cheaper call with strike B to limit your risk if the stock goes up. But there’s a tradeoff — buying the call also reduces the net credit received when running the strategy.
Options guys tips
One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.
You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this strategy.
As a general rule of thumb, you may wish to consider running this strategy approximately30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.
The setup
Sell a call, strike price A Buy a call, strike price B Generally, the stock will be below strike A
Who should run it
Seasoned Veterans and higher
When to run it
Options Playbook image 3Options Playbook image 4
You’re bearish. You may also be expecting neutral activity if strike A is out-of-the-money.
Break-even at expiration
Strike A plus the net credit received when opening the position.
The sweet spot
You want the stock price to be at or below strike A at expiration, so both options expire worthless.
Maximum potential profit
Potential profit is limited to the net credit received when opening the position.
Maximum potential loss
Risk is limited to the difference between strike A and strike B, minus the net credit received.
Margin requirement
Margin requirement is the difference between the strike prices.
NOTE: The net credit received when establishing the shortcall spread may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As time goes by
For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).
Implied volatility
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.
If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).
What is a bear put spread?
The strategy
A long put spread gives you the right to sell stock at strike price B and obligates you to buy stock at strike price A if assigned.
This strategy is an alternative to buying a long put. Selling a cheaper put with strike A helps to offset the cost of the put you buy with strike B. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.
Options guys tips
When implied volatility is unusually high (e.g., around earnings) consider a long put spread as an alternative to merely buying a put alone. Because you’re both buying and selling a put, the potential effect of a decrease in implied volatility will be somewhat neutralized.
The maximum value of a long put spread is usually achieved when it’s close to expiration. If you choose to close your position prior to expiration , you’ll want as little time value as possible remaining on the put you sold. You may wish to consider buying a shorter-term long put spread, e.g., 30-45 days from expiration.
The setup
Sell a put, strike price A Buy a put, strike price B Generally, the stock will be at or below strike B and above strike A
Who should run it
Veterans and higher
When to run it
Options Playbook image 3
You’re bearish, with a downside target.
Break-even at expiration
Strike B minus the net debit paid.
The sweet spot
You want the stock to be at or below strike A at expiration.
Maximum potential profit
Potential profit is limited to the difference between strike A and strike B, minus the net debit paid.
Maximum potential loss
Risk is limited to the net debit paid.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you bought (bad) and the option you sold (good).
Implied volatility
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.
If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the out-of-the-money option you bought faster than the near-the-money option you sold, there by increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).
What is a bearish strategy?
Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.
What is a covered put sale?
Refer to paper notes.
What is a long put?
The strategy
A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short. The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock price rises.
But when you use puts as an alternative to short stock, your risk is limited to the cost of the option contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you would with short stock. You simply allow your puts to expire worthless or sell them to close your position (if they’re still worth anything).
But be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment.
Puts can also be used to help protect the value of stocks you already own. These are called protective puts .
Options guys tips
Don’t go overboard with the leverage you can get when buying puts. A general rule of thumb is this: If you’re used to selling 100 shares of stock short per trade, buy one put contract (1 contract = 100 shares). If you’re comfortable selling 200 shares short, buy two put contracts, and so on.
You may wish to consider buying an in-the-money put, since it’s likely to have a greater delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). You can learn more about delta in Meet the Greeks . Try looking for a delta of -.80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.
The setup
Buy a put, strike price A Generally, the stock price will be at or below strike A
Who should run it
Veterans and higher
When to run it
Options Playbook image 3
You’re bearish as a grizzly.
Break-even at expiration
Strike A minus the cost of the put.
The sweet spot
The stock goes right in the tank.
Maximum potential profit
There’s a substantial profit potential. If the stock goes to zero you make the entire strike price minus the cost of the put contract. Keep in mind, however, stocks usually don’t go to zero. So be realistic, and don’t plan on buying an Italian sports car after just one trade.
Maximum potential loss
Risk is limited to the premium paid for the put.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.
Implied volatility
After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is down).
What is a protected short sale?
Refer to paper notes.
What is a synthetic put?
A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It’s also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock.
Short call.
The strategy
Selling the call obligates you to sell stock at strike price A if the option is assigned.
When running this strategy, you want the call you sell to expire worthless. That’s why most investors sell out-of-the-money options .
This strategy has a low profit potential if the stock remains below strike A at expiration, but unlimited potential risk if the stock goes up. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money options. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.
Options guys tips
You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the higher the strike price, the lower the premium received from this strategy.
Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.
The setup
Sell a call, strike price A Generally, the stock price will be below strike A
Who should run it
All-Stars only
NOTE: Uncovered short calls (selling a call on a stock you don’t own) is only suited for the most advanced option traders. It is not a strategy for the faint of heart.
When to run it
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You’re bearish to neutral.
Break-even at expiration
Strike A plus the premium received for the call.
The sweet spot
There’s a large sweet spot. As long as the stock price is at or below strike A at expiration, you make your maximum profit. That’s why this strategy is enticing to some traders.
Maximum potential profit
Potential profit is limited to the premium received for selling the call.
If the stock keeps rising above strike A, you keep losing money.
Maximum potential loss
Risk is theoretically unlimited. If the stock keeps rising, you keep losing money. You may lose some hair as well. So hold onto your hat and stick to your stop-loss if the trade doesn’t go your way.
Margin requirement
Margin requirement is the greater of the following:
25% of the underlying security value minus the out-of-the-money amount (if any), plus the premium received OR 10% of the underlying security value plus the premium received
NOTE: The premium received from establishing the short call may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-contract basis. So don’t forget to multiply by the total number of contracts when you’re doing the math.
As time goes by
For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
Implied volatility
After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.
The strategies that are available when one is bearish and how to pick strike prices
- The different option strategies available to bearish investors are long put, protected short sale, covered put sale,
short call, bear put spread, and bear call spread. - The choice of strike prices depends on the extent of an investor’s bearishness.
