where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
This edition of Profit Talk we’re going to cover some of the details regarding the bearish side of trading. We’ll look at the premise behind bearish style strategies and go over the pros and cons associated with taking the short side of the trade. In addition we’ll cover the details for creating a bearish option position.
Up to this point, the strategies we’ve focused on in the Profit Talk issues have been bullish or neutral, directionally speaking. I have avoided covering bearish strategies for two main reasons. First, most people are much more familiar and therefore more comfortable with the concept of a buy style strategy. Another big reason is the fact that since launching Profit Talk, the US stock market has been experiencing one of the most incredible bulls runs in history and bearish strategies are poor choices for use in bullish uptrends. But, as you’ll soon learn, markets that do warrant a short sell or bearish position can be found in almost any type of market environment, including this one. And, having the ability to trade both sides of the market can create some great opportunities for profits and enjoyment.
Most people are very familiar with the idea behind a buy style trade or investment. The goal is to buy an asset now with hopes of selling the asset some time in the future for a higher price, pocketing the difference. To create profit the asset must be sold at a higher price than it was purchased. An investor or trader applying this strategy would be considered “bullish” on the price of that asset. That is, they believe the asset is going higher in the future. If holding a bullish position they may say they are “long the market”.
Bearish style strategies have the exact opposite outlook for the particular market. They believe the asset is going lower and are therefore bearish. The method for profiting is also the exact opposite. The bearish trader sells the asset first with hopes of buying it back later at a lower price and pocketing the difference. This type of trader is also referred to as a short seller. If holding a bearish position they may say the are “short the market”. The financial marketplace allows traders to sell an asset they don’t own. Selling an asset you don’t own is referred to as “shorting” the asset. The actual mechanics involved when shorting a stock involves borrowing shares to sell them. This means you are “short” the shares or negative the shares. In order to close out the position you must buy the shares or contracts you are short. This is often referred to as “covering” the position.
However, as you’ve learned, Options can be both sold or purchased to facilitate bearish or bullish positions. So, Option traders will take care to express their directional opinion or position by saying they are bullish or bearish rather than just long or short a particular market.
As with everything else, there are pros and cons with bearish style trading. The positives are, bearish strategies offer opportunity to profit when the markets are going down. This gives you the ability to trade both sides of the market. Without utilizing bearish strategies a trader is trading only ½ the market. This leads to a lot of missed opportunities. Also, the ability to trade both sides of a market provides opportunities for hedging and or spread style trades.
Another advantage is the quick manner in which you get paid when trading the short side. People react much stronger to fear than to greed. If you look at a typical price chart, you’ll see that price moves to the down side much quicker than it does to the upside. You can see that far less bars are used to lower price than raise it. For this reason, when bearish trades work out, they tend to do so much quicker compared to bullish trades. (Figure 1)
The downsides include- First, the total profit that can be made is limited. The lowest price an asset can go to is zero. The total amount of profit that can be made is the difference between the asset price when it is sold and zero. Bullish trades have no such “built-in” price limit as there is no cap on how high a price can go. For this reason, lower priced stocks are avoided when looking for bearish candidates.
Another risk associated with a bearish strategy that does not exist with bullish style strategies is called “takeover risk”. The announcement of a buyout offer or stock takeover attempt creates risk for bearish positions. The risk comes from the possibility of a significant increase in price caused by the announcement of a takeover or even the rumor of one. If an offer is made at a price higher than the current price, the price will almost surely trade at or above the buy price offered. Remember, bearish trades profit from falling prices and lose money with rising prices in the particular market. They are based on selling the asset first with the intent to buy it back later at a lower price.
The immediate and possibly substantial rise in price that may accompany such an announcement traps all the short sellers in the market that are now underwater in the trade. These traders must buy the stock to close out or reduce the directional risk in the trade. This buying adds fuel to the fire sending prices higher. In the case of a true takeover that goes through, the stock shares will eventually cease trading as the company is absorbed into the buyer. I think this is the worst part of the takeover risk. A market that continually trades provides the ability to recoup losses by continually selling premium against the losing position. Plus, there is opportunity for price reversion. If the stock ceases to trade all that opportunity disappears.
This is one of the big reasons I stress trading ETFs so much, there is no possibility of a takeover on an ETF. Another way to avoid, or at least greatly reduce the risk of takeover is to stick to companies with higher market capitalization. That is the biggest companies, ones that are too large for any other company to buy. When I say large, I mean large, as in large market capitalization, not “famous”. The market capitalization is calculated by multiplying the number of shares by the current share price or through a ticker symbol search. Yahoo Finance has the information under statistics. Stick to the biggest stocks or ETFs when placing bearish trades to avoid takeover risk.
Another risk when short a market comes from the payment of a dividend. If you are short the shares of a stock with a dividend payout, you are obligated to pay the dividend. The day the dividend is paid the stock price will be reduced by an amount equal to the dividend, at least in theory. So, it should be a wash. However, in practice, the open trading price of the asset is dictated by market conditions.
Options traders can be “short” a market, that is, they can create bearish trades in a market through buying a Put or selling a Call. In the case of Put buying, there is no dividend risk, everything is included in the pricing and washes out. Calls on the other hand, are a different story. But, only when they are in the money. In the money Calls have risk of assignment.
Assignment is when the obligation the short Option brings is realized. In the case of short Calls the holder is obligated to sell the underlying stock if the Calls are exercised. This means, the account holding the short ITM Calls that are assigned stock will now hold 100 short shares for each Call exercised. The buyer of the Call exercises their right to receive the shares in order to receive the dividend.
As covered, the value of the dividend is removed from the price of the stock on the day of the dividend payout, so technically speaking, everything should balance out. But, assignment does have a small fee involved and holding short shares takes more buying power than holding short Calls. Because of this, short ITM Call positions should be monitored and managed accordingly.
If the extrinsic value of the short ITM Call you are holding is more than the dividend being paid, assignment is very unlikely. If the extrinsic value is less than the dividend, assignment is almost guaranteed. Extrinsic value of a Call is determined by subtracting the intrinsic value from the current value of the Call. The intrinsic value of the Call is determined by subtracting the Call strike price from the current stock price.
For example, if the ITM Call has a strike price of 50 with a value of $5.25 and the stock is trading for $55.00 per share, the extrinsic value of the Call option is 25 cents.
Subtracting the Call strike price, $50 from the current stock price of $55 gives an intrinsic value of $5 for the Call option. The current value of the Call option is $5.25. Subtracting the intrinsic value of $5 from the Call value of $5.25 leaves an extrinsic value of 25 cents. If the dividend payment in this example is more than 25 cents the Call will most likely be exercised. If the dividend payment is expected to be less than 25 cents, it’s extremely unlikely the Calls would be exercised. Assignment can be avoided by rolling the short Call further out in time to gain more extrinsic value. Roll out to a Call that has more extrinsic value than the dividend payment.
Bearish positions can be created using Options by either selling Calls or buying Puts. As is in the case with all option positions we create, the IV Percentile must be considered and the appropriate tactic used accordingly. Remember, as it pertains to the option itself, long option strategies are used when IVP is low and short option strategies are used when IVP is high. This means we select the style of option strategy to use based on the current IVP of the market we’re trading. This edition of Profit Talk, we’ll go through the process of creating a bearish position in a low IVP environment called a “Bear Put Spread”.
Bear Put Spread
The bear put spread is a directional style option spread that is best used when the IVP is 40% or less and the directional assumption is for lower prices. The spread is constructed using two Put options, one long ITM Put and one short OTM Put that expire in 90 days or more. Remember, when it comes to creating a debit style options strategy, that is a strategy with a long option as the profit driver, we’re better off using longer duration options. This is because the time decay of the option is slower in the the longer duration options. For more detail regarding Option characteristics review the 12-19-2016 edition of Profit Talk called “Call & Put Basics”.
To create the spread, choose a 90 + days expiration cycle and buy a Put option that is one or two strikes in the money. Generally, a delta value somewhere between -.55 to -.65 deltas works well for the long option. Then sell a Put option that is at or below the range, usually a short Put with -.15 to -.25 deltas works. The goal is to create a spread with at least -.25 deltas. Adjust the strike prices to create a spread with at least -.25 deltas.
This style of spread will profit when the stock price moves down and will lose when the stock price moves up. There are some great advantages to using this style of position compared to just shorting the stock. First, this style of spread has limited risk. You can not lose more than you paid for the spread no matter what happens. If a takeover occurs or a surprise announcement suddenly boosts the stock price, the total amount you can lose will not exceed the cost of the spread.
In addition, the amount of capital tied up for holding the position is far less than when shorting the stock. This allows for a much better return on capital and therefore more efficient use of capital.
The downside with this style of spread is the total profit potential is limited at the point of the short strike. However, based on my experience, a forced exit point for profit does provide a great advantage. The motivation for closing the trade once the max profit is realized is high and therefore reinforces the proper behavior of taking profits and moving on to the next trade.
In regards to determining the risk defense point and the profit targets, the rules we use for any directional trades can be followed. For more details, review previous Profit Talk issues that cover directional trading. They can be located on the e-letter archive page under the “directional trading” category. If the risk defense point is reached, the stock neutralization technique covered in the 02/20/2017 edition of Profit Talk called “Directional Trading Essentials” can be used.
The main takeaways regarding bearish positions are:
First, bearish strategies derive profit in the opposite way from bullish, they profit when prices fall.
Second, the main advantage is due to the ability to trade both sides of the market allowing an investor to profit in falling markets and or hedge positions. Plus, the practice opens up opportunities for pairs trading.
Third, the disadvantages or risks involved beyond the directional move against the position that can occur, are takeover risk and dividend risk. Make sure to manage these risks accordingly.
Last week the Federal Reserve made their much anticipated announcements regarding interest rates. The outcome was as expected, which was a ¼% rise in the Fed Funds Rate. The equity markets reacted strongly to the upside with this news. However, since the announcement and subsequent reaction, the broad markets have traded sideways for the most part and have given back some of the upside movement. This sideways action has brought price into the bullish trend trading zone for the S&P as represented by the ETF ticker SPY. I would normally say entry here for a bullish trend trade is perfectly acceptable, I avoid entry when the outer bands on the Bollinger bands have contracted like this. (Figure 2)
The high impact reports due out this week include:
Wednesday 3/22 - Crude Oil Inventories are released at 10:30 am eastern
Thursday 3/23 - Unemployment claims at 8:30 am easter and Fed Chair Janet Yellen scheduled to speak at 8:45 am
Friday 3/24 - The Core Durable Goods orders reports will be released at 8:30 am eastern
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.