Profit in a Falling Market (With Limited Risk)
Although the coronavirus outbreak remains a major problem, the stock market nevertheless rallied to new record highs in the late summer.
Extremely dovish monetary policy and expectation of a fast economic rebound encouraged risk taking. Lately, however, investors are wondering if the market rally has priced in too fast an economy recovery. After five straight monthly gains, the S&P 500 looks on track to book its first losing month since March.
For investors who want to have more flexibility than just selling or shorting, options offer a way to hedge against continued weakness or just bet against stocks.
The most straight-forward way is to buy a put. But many seasoned options traders like to use a combination of options to better manage risk.
The Bear Call Spread
One such strategy is the bear call spread.
The strategy involves selling a call option and simultaneously selling another call option on the same stock with the same expiration date but a higher strike price. The key here is that the premium you receive for selling the put is higher than the premium you paid. You end up with a net credit.
For example, you could sell a Cloudflare (NYSE: NET) December 38 call for about $4.50, and buy a NET December 40 call for about $3.70. You will receive a net credit of $80 per contract traded (not counting the negligible commissions).
The graph plots the gain and loss of this spread if both legs of the trade are held to expiration.
If NET ends up at $38 or less at expiration, both calls just expire. The credit of $80 is yours. The best possible situation is when the stock ends up below the strike price of the short call.
If NET ends up above $40, your maximum loss occurs. Both calls will be exercised. You end up buying 100 shares of NET at $40 and you have to sell 100 shares of NET at $38. You lose $200 in the transaction. But since you collected a $80 credit in the beginning, your net loss is $120.
As you can see, your maximum gain is capped at $80. But if you feel that the stock will go down, it’s a way to profit while keeping your maximum loss small. As the graph shows, your maximum loss is capped at $120, which means your downside risk is significantly lower than if you sold a naked call. The maximum potential loss in writing a naked call is theoretically limitless.
If you were to buy a NET December 38 put instead, it would cost you about $4.70. You would have higher potential upside, but you could also lose the entire $470 per contract. Moreover, you need NET to be above $33.30 at expiration to make a profit since you paid a $4.70 premium. The graph shows what the gain/loss looks like.
The Bear Put Spread
If you wanted to do a bear spread with puts, that’s doable too.
Like a bear call spread, you also buy one put and short one put with the same expiration date. Here, too, you long the put with the higher strike price and short the put with the lower strike price.
Continuing the example with NET, you could buy the NET December 38 put for $4.50 and short the NET December 36 put for $3.55. You will end up with a debit of $0.95.
If NET ends up $38 or higher at expiration of the December contracts, both puts will expire. You lose $95. That’s your maximum loss.
If NET is $36 or lower, both puts are exercised and you achieve your maximum gain: $105. You have to buy 100 shares of NET at $36 but you get to sell 100 shares at $38. The difference is $200, but you have to net out the $95 you paid. The graph shows the gain and loss.
As you can see, the graphs are quite similar. You benefit in both cases when the stock falls. The tradeoff is that you limit your maximum gain but you also limit your maximum loss. The main difference is that when you do a bear call spread, you collect your maximum profit up front.
Of course, the graphs assume that you hold both legs of the spread to expiration. In reality, you can close any legs at any time, so depending on how good your timing is, you could do better or worse than the graphs indicate.
Editor’s Note: Scott Chan has just given you valuable investing advice that can help you make money, even in a down market. But we’ve only scratched the surface of the expertise available on our team.
For specific ways to make money during the coronavirus crisis, consider the advice of our colleague Jim Fink, chief investment strategist of Velocity Trader.
Jim Fink is a millionaire and investing legend who has developed an options trading strategy that’s making his followers rich. Jim’s guidance generates gains regardless of the pandemic or economic ups and downs.
In a new presentation, he reveals how you can use his strategy to extract $2,440… $5,200… even $7,890 from the market… every single week. Want to know more? Click this link.