CHAPTER lll - LONG STOCK PART 2 [Bear Put Spread / Rolling Over]

BEAR PUT SPREAD

In reality, if you want to get insurance for your vehicle or house and the rates are too expensive, you have no option but to pay if you want safety and peace of mind. The benefit of utilizing options to offer insurance is that there is a method to cut insurance costs if option premiums for a specific stock are particularly high. In addition to acquiring a long put to hedge your stock position, you may also sell a put at a lower strike price with the same expiry date to generate some premium and lessen your long put cost.

When the lower strike put is sold, the protective put becomes a bear put spread. A bear put spread's maximum profit potential is the difference between the strike prices minus the debit paid for the position. For example, if you purchased an EBAY $110 Put for $4.00 and sold an EBAY $105 Put for $1.00, your net debit would be $3.00 and your maximum profit on the spread at expiry would be $2.00 ($5.00 difference in strikes minus $3.00 debit).

The bear put spread does not totally hedge the stock position or give a capped maximum loss in return for the cheaper insurance cost. Instead, the bear put spread just mitigates the loss that happens when the stock falls in value. As a result, it is just a partial hedge. However, by combining various strike price combinations, you may generate varying amounts of partial hedges to fit your requirements and match the predicted price movements of the underlying stock.

Using the previous example, suppose you bought 100 shares of EBAY at $100 and it has now risen to $110. You want to hedge your stock position with a protective put because you are concerned about a price reversal. A 2-month EBAY $110 put is selling for $4.60, while a 2-month EBAY $105 put is trading for $2.00. Simply purchase the $110 Put for $4.60 to hedge the stock position. If you think this price is a little excessive for EBAY protection, you might buy the $110 Put and then sell the $105 Put for a net negative of $2.60. At expiry, the maximum profit from the bear put spread is $2.40 ($5.00 strike price difference minus $2.60 net debit). When you purchased a protective put for EBAY when the stock price reached $110, you secured a minimum profit. With bear put spreads, there is no minimum profit guarantee, just a partial hedge against the stock's price decline. For instance, if EBAY fell to $95, the stock would have a $5 loss, while the bear put spread would earn $2.40, for a total loss of $2.60. Consequently, the bear put spread mitigates a portion of the loss, but you still incur a loss. The combined position has a breakeven point of $97.60. At that price, the stock loss of $2.40 would match the profit on the bear put spread. This may be used as the closing price for the whole position. Because EBAY was trading at $110, the breakeven and target price of $97.60 offers the company enough space to decline without incurring a loss. Figure 3.8 contrasts the usage of the protective put alone with the use of the bear put spread.

Therefore, the bear put spread minimizes the magnitude of the position's loss but does not eliminate it totally. The absence of a guaranteed minimum gain is counterbalanced by the fact that the bear put spread decreased your insurance premium by over 50 percent, from $4.60 to $2.20. The bear put spread is a decent alternative to a single protective put when options are relatively costly or when the predicted decline in the stock price will not exceed the breakeven point generated by the bear put spread. In the above example, if you believed that EBAY may fall below $95, the protective put would provide more protection than the bear put spread with a breakeven above $95.

As with any investing decision, the option boils down to a comparison of the risk/reward adjustments made to your principal stock investment by the protective put vs the bear put spread, and which profile more closely matches your expectations for the underlying company.

ROLLING FROM A PROTECTIVE PUT INTO A BEAR PUT SPREAD

You may roll a protective put hedge into a bear put spread even if you want to hedge a long stock position with a protective put. You may minimize the cost of your insurance coverage and perhaps gain money by rolling into a bear put spread without removing your hedge. This is seen in our previous example of adding a protective put on EBAY when it goes from $100 to $110. Remember how, when EBAY reached $110, you decided to buy a 2-month $110 Put for $4.60? With the EBAY $105 Put trading at $2.00 and the worry that EBAY would drop to $100 or below, you decide against using the bear put spread since it will restrict the hedge from the long put. Even though the $100 Option is now selling at $1.50, you are reluctant to utilize a bear put spread because you are concerned that EBAY will go below $100 and want the strongest protection possible, even if it is more expensive. This is only possible with the protective put, which lets you to lock in a little profit.

If EBAY falls to $101 after a few weeks, your $110 Put has locked in a minimum profit of $5.40 ($1.00 stock profit + minimum $4.40 profit on EBAY $110 option, but it may be higher given the time value premium remaining on the put).

Some traders may sell the put to cover the cost of the insurance and profit from the deal, and then let EBAY to go higher for extra gains. The $4.40 profit from the protective put lowers your EBAY breakeven point and allows you more space for downward movement before a loss occurs. Any change that lowers your breakeven point is usually beneficial. However, if you remove your insurance coverage, you are no longer hedged, which is not smart risk management. With options, you may repay the cost of the insurance, earn a profit, and keep your insurance policy.

Because you still want to maintain your hedge in place while recouping your insurance costs, you may sell the $105 Put to bring in enough premium to pay your insurance costs and convert the protective put into a bear put spread. If the EBAY $105 Put is now selling for $5.25, you may sell it to roll into a bear put spread and earn $5.25 in premium. Because you spent $4.60 for the long put, rolling into a bear put spread and earning $5.25 recovers your expenditures and creates a risk-free spread. Furthermore, you brought in an extra $0.65 in credit, which is guaranteed further profit from the put spread. You maintain the $0.65 credit regardless of where EBAY is at the time of expiry. As a result, the maximum profit on your bear put spread is $5.65, which is the difference between the strike prices ($110 - $105) plus the $0.65 credit. If EBAY is still at $100 at the time of expiry, you will have made $5.65, a solid 2-month return for a company that moved from $100 to $110 back to $100. Any profit on EBAY over $110 is lowered by the spread cost with a debit bear put spread.

By rolling into the bear put spread for a credit, however, you enhance EBAY's profit over $110 by the amount of the credit obtained. You have set a breakeven point for the trade by rolling into the bear put spread since you are no longer entirely hedged by a protective put (Figure 3.9). The breakeven point for rolling into a bear put spread on EBAY is $94.35 because the loss in the stock is totally covered by the profit from the bear option spread at that price. This provides a significant cushion from $101 enabling you to exit the trade with a profit if the price continues to fall. You may be wondering why you should roll from a protective put position with a guaranteed minimum profit into a bear put spread, which might really result in a loss if the price falls far enough. The answer is determined by your expectations. The protective put is a superior downside hedge on its own, but the cost of the hedge cuts into EBAY earnings on the upside if the stock rises. If you believe EBAY has bottomed out following a price decrease, you may roll into a bear put spread to recover your insurance costs and then participate fully in the stock's upward climb. You do, however, have some downside protection. Remember that rolling into the bear put spread does not eliminate the hedge totally, but it does decrease the stock's breakeven point, providing you some space to absorb additional negative volatility. If the stock reaches the new breakeven price before the expiry date, you simply close the trade with no loss. Your option adjustments will essentially enable you to ride EBAY from $100 to $110 to $94.35 without incurring a loss to your trading capital. Obviously, you anticipated that EBAY would not drop much from $110 and continue to rise, but you made precautions in case it did not cooperate. In this manner, alternatives are used for efficient risk management. As a consequence of rolling your defensive put into a bear put spread, you will still generate a profit if you close out EBAY between $94.35 and $100. If EBAY is at or above $110 at expiry, you recoup the cost of the protective put plus get a $0.65 credit since the options expire worthless, resulting in a complete profit on the stock.

A further benefit of rolling into the bear put spread for a credit is that you may still buy an extra protective put on the position if you need further protection. As a result of recovering the cost of your first protective put with EBAY at $101 by rolling into a bear put spread, you have the option to buy another protective put at $100. If a $100 Option with the same expiry date as the bear put spread is priced at $3.75, you may now buy the protective put to fully hedge EBAY. In addition, since you received a $0.65 credit, the true cost of the new protective put is $3.10.

With the bear put spread, the breakeven point for the position is $94.35. Adding a second protective put eliminates the position's breakeven point since a profit is now assured. If EBAY is at $100 at expiry, you will incur no loss on the stock position, earn $5.00 on the bear put spread (note that the credit is now applied to the cost of the new protective put), and lose $3.10 on the worthless protective put, for a net profit of $1.90. The profit stays unchanged at $1.90 while EBAY falls below $100. If EBAY is trading at $90, the stock loss is $10.00, the bear put spread profit is $5.00, and the protective put profit is $6.90, for a net profit of $1.90. Above $100, the profit potential on eBay is infinite. Thus, by rolling the protective put into a bear put spread in exchange for a credit, you may buy another protective put at a discount.

Your expectations will determine whether or not you should roll from a protective put to a bear put spread. If you acquire a protective put and are still concerned about a significant decline in the price of EBAY, you are better off holding your protective put to lock in a minimum gain than rolling into a bear put spread. Nonetheless, if you roll into a protective bear put spread for a credit and still want to hedge your position, you may use the net credit to buy a protective put with a lower strike price and lock in a profit. ROLLING FROM A BEAR PUT INTO A PROTECTIVE PUT

Rolling from a protective put into a bear put spread is possible, as is rolling from a bear put spread into a protective put. Assume, as previously, that you acquired the $110/$105 bear put spread for a net negative of $2.60 after EBAY increased from $100 to $110. If EBAY then makes a substantial increase to $115, put premiums will decrease. If the price increase is temporary and you anticipate a price reversal in EBAY, you may simply sell the stock for a profit and either close out the put spread to recover the remaining value or let it run in the event that EBAY reverses and goes down in price. The return on the investment will exceed the original cost of the bear put spread.

If you are hesitant to sell your EBAY shares but remain concerned that the company is due for a significant price fall, you might simply do nothing since you have a bear put spread in place.

However, if you are feeling anxious, you may be more likely to lock in a minimum guaranteed profit in order to withstand any downward price pressure and weather the storm. To turn the bear put spread into a protective put, the optimal modification would be to purchase back the short $105 Put. As previously said, the $105 Put was sold for $2. Assume that with EBAY trading at $115, the $105 put has decreased in value to $1.00.

If you repurchased the put for $1.00, your cost basis for the $110 put would be $3.60 (net debit of bear put spread of $2.60 + $1.00 to repurchase the short $105 Put). You spent $4.60 for the $110 Put and earned a profit of $1.00 on the short $105 Put, resulting in a net cost of $3.60 for the revised cost basis. By rolling the bear put spread into a protective put following EBAY's price increase, you decreased the total cost of the protective put from $4.60 to $3.60.

By repurchasing the short put, you raised the cost of your insurance by $1.00, bringing the total to $3.60. However, the benefit of the $1.00 premium is the assurance of a minimum profit of $6.40 on the $110 Put until expiry, regardless of where EBAY trades. This modification is simpler to make if the stock price increases after the bear put spread has been set. When the stock price increases, the value of the short put decreases, making it simpler to repurchase the put. If the stock declines after adding the protective spread, the cost to repurchase the short put would increase. If the additional cost of repurchasing the short put still assures an acceptable minimum gain, rolling the bear put spread back into a protective put remains an option if total protection is wanted.

If you wanted to exit the bear put spread after EBAY dropped from $110 to $105, you would have to purchase back the short $105 Put.

If the price of the $105 Put rose from $2.00 to $3.50, you would be required to pay $1.50 to close out the short put. This would result in the effective cost of the $110 Put increasing from $2.60 (net negative for the spread) to $4.10 This is still less than the initial price of $4.60 for the protective put. Consequently, it is possible to roll from a bear put spread to a protective put and still pay less than the initial cost of implementing the protective put.

Because a bear put spread merely limits the possible loss and does not give a guaranteed profit, it is sensible to convert the spread into a protective put if you believe the probable decline in EBAY's price warrants more protection. If you believe that the price of EBAY will drop significantly and continue to decrease, closing the whole trade is the best option. If you still believe the stock will increase, it makes sense to hang on to it; but risk management dictates that you purchase the greatest available hedging. Rolling into a protective put for a locked-in profit is the ideal course of action if the probable short-term decline in the stock price seems to be substantial.

A put option guarantees the price at which we may sell shares. Therefore, the put is the simplest adjustment to make to a long stock position in order to hedge against a price decline. You should anticipate that the stock will rise at some time. Applying a protective put or bear put spread to a long stock position enables you to manage and limit downside risk while still participating in the stock's upward movement. Otherwise, the wisest course of action would be to just sell the stock and reduce your losses.