LEAP Bear Spreads: If You Want to “Go Short,�? This is the Way to Do It

LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It

by Karim Rahemtulla, Options Expert
Tuesday, July 27, 2010: Issue #1310

It’s time to take a risk.

But not like 99% of the other suckers in the market, who spy an opportunity and, with little regard for their own financial well-being, jump in with both feet.

No… we’re going to take much better approach to risk.

If you remember from my article last week, I outlined the pitfalls of trying to profit from declining stocks by selling them short.

It’s a risky strategy, with two main problems…

• Liquidity: When you want to short shares, you have to borrow them from your broker. This isn’t usually a problem when you want to short larger stocks. But it can be trickier when smaller stocks are involved.
• Unlimited Losses: Need I say more here? If the share price goes against you – i.e. the stock rises – your risk is theoretically unlimited. Because you don’t own the shares in the first place (you’re just borrowing them), you eventually need to replace them. And if you’re paying more to do that than the price at which you borrowed them, you’re sitting on a major losing trade.

However, you do need to be able to “go short” without worrying about liquidity or being totally exposed to unlimited losses, which you can do with an options strategy known as a bear spread, but first let me give you a bit of background…

A Balanced Portfolio: The Short and Sweet of It

Because the market doesn’t always rise, part of a balanced portfolio should include being able to successfully capture gains when stocks fall. When a downward trend develops, you don’t want to get caught on the sidelines because you’re either too scared or because you don’t know how to do it.

For example, let’s say you think that the financial sector is going to collapse again, you have three choices:

1. Shorting: In this case, you’d short the Financial Select Sector SPDR (NYSE: XLF) – the exchange-traded fund (ETF) that holds a basket of major financial stocks. The problem is that your risk is unlimited. I mean, if I knew for sure that a stock was going to collapse, I wouldn’t be sitting on a plane writing this article while en route to speak at a conference. I’d be long retired. Here are better ways of doing that without resorting to the risky shorting strategy…
2. Buy Short-Term Put Options: Again, you could use XLF here. They’ll cost you less upfront, but you’re not saying that you can predict the future when you buy a short-term option. Risk is limited.
3. Buy Long-Term Put Options: Why not give yourself the luxury of time by using LEAPS instead of short-term options? If you buy a LEAP put option on XLF, you put time on your side (one to two years, specifically) and you can make an educated guess based on information at hand. Risk is limited to the money you invest.

There’s another great way to grab downside gains, too…

The Breakdown of a LEAP Bear Spread

Again, using LEAP options, the bear spread strategy allows you to reduce your initial outlay. The trade off is that it also caps your return.

This is a type of options strategy that you use when…

1. You think a stock is headed lower, but not necessarily going out of business.
2. When you’re trying to short a volatile stock, since options premiums are much higher on volatile stocks.

Here’s how it works:

• Stock XYZ is trading at $40, but you think it’s headed for $25.
• You can buy $40 put options for around $5, with a one-year expiration.
• In order to control 1,000 shares, you buy 10 contracts (there are 100 underlying shares in each options contract). So your total cost is $5,000 ($5 multiplied by 100, then multiplied by 10 = $5,000).
• Risk: Limited to $5,000.
• Profit: If XYZ goes to $25, you’ll make a $10,000 profit:

  $40 minus $25 minus $5 (the cost of the option) multiplied by 1,000 (the number of shares you’re controlling) = $10,000.

Pretty nice. But it could be even better.

The $12,000 Short Spread

Instead of risking $5,000 to make $10,000, you could risk $3,000 to make $12,000. Here’s how…

• Buy the same $40 strike option for $5.
• But against that option you sell a $25 put option, which is trading for $2. Your cost is $3 ($5 minus $2). For the same 10 contracts as before, that would cost you $3,000.
• Risk: $3,000
• Profit: If the stock falls to $25, the upside is $12 (or $12,000):

  $15 (the spread between $40 and $25) minus your $3 cost for the spread, multiplied by 1,000 (the number of shares you’re controlling) = $12,000.

You accomplish three things here…

1. Pull almost half your investment off the table.
2. Increase your potential return.
3. Lower your risk to the amount you spent on the spread – not a penny more.

The catch is that if the shares move lower than $25, you’re still only entitled to the spread and no more.

So if you want to capture gains from a stock’s downside, think twice before going down the “short road.” Instead, use put options to accomplish the same thing, but with less cost and less risk.

But not just the put options that everyone else uses. Use LEAPS, so you can control the amount of cash at risk. It sure beats the unappetizing thought of sitting on unlimited risk and getting a call from your broker, asking you to send more cash because the underlying shares went to the moon.

Good investing,

Karim Rahemtulla

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