by Lawrence Meyers | April 23, 2013 9:32 am
What can you do if you think a stock might crater, but you aren’t committed enough to short it or to just buy puts outright on it?
Try the short bear ratio spread.
Done properly, this options strategy not only eliminates upfront payment, but give you unlimited profit potential.
The short bear ratio spread requires you to buy several at-the-money (ATM) put options, or just slightly out-of-the-money (OTM) put options. You’ll finance these purchases by selling a smaller number of in-the-money (ITM) put options, which will ideally yield a higher premium, the proceeds of which you’ll use to buy the other puts.
The variable factors at play here are exactly which strike prices to use. You’ve got several things to consider here.
If the number of ITM short put options is equal to or exceeds the number of long puts, it’ll be a losing trade if the underlying stock goes up. That doesn’t make for a good bearish strategy.
If the short puts cost more than the long puts, a net credit results, which allows you to profit if the underlying stock falls drastically. This gets you partially to your goal of a big gain if the stock craters, but there’s more volatility here than you’d like.
If the strike price differential between the short and long puts is narrow, then you get the best potential profit and you’ll be closer to the lower breakeven point. However, the wider the strike price differential, the less ITM put options you would need to sell to cover the price of the long puts, which pushes that lower breakeven point down further.
The bottom line, then, is to try and sell the nearest ITM puts that cover the cost of the all the long put options
Your maximum profit in this scenario is unlimited. You want the stock to crater so those multiple puts you are long on will rise in value.
Your maximum loss is limited. It occurs when the underlying stock closes exactly at the strike price of the long puts.
You actually have two breakeven points in this scenario. The “lower breakeven point” is price below which the position will start to make a profit. The “upper breakeven point is the point above which the position will lose only the net debit (if there was one).
Let’s take an example. Green Mountain Coffee Roasters (NASDAQ:GMCR) — which trades just above $55 as of this writing — reports earnings on May 3. Maybe you expect a big drop.
Sell 1 May 60 Put for $7.70. Use the proceeds to buy 3 May 50 Puts for $2.75. You’ll have a net debit of only $55.
The earnings report stinks. Green Mountain falls to $40. You’ll have 100 shares put to at $60. Bummer. That cost you $2,000. However, your May 50 Puts are now all worth about $11.40 each (accounting for approximate time premium). That adds back $3,420. You end with a total profit of $1,365.
You maximum loss occurs if the stock only goes to $50. You’ve had shares put to you at $60 and now they are at $50. You’re out $1,000.
But if the stock goes up, you’ve only lost the $55. That’s the difference between this trade and just buying a straight put, which could be worth zero if the stock rises.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets @ichabodscranium.
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