Bearish options strategies for value investors

Bearish options strategies provide value investors a great set of tools to implement a bearish bias in their portfolios with time limits. It is also possible to implement strategies that mimic the level of bearishness you would like to see reflected in the portfolio. Below are the strategies that can be used:

Strong bearish strategies:

The simplest bearish strategies involve buying puts or selling calls. Long puts or short calls on one of the ETFs covering the major markets (SPY, VTI, QQQ, etc) can be used to build a strong bearish bias that will inversely correlate with the specific market as a whole. However investing in derivatives of the major market indexes has downsides including the fact that it is suitable only when the markets have topped out – determining the exact top is a gamble best avoided. The classic dilemma that face value investors using long puts or short calls as a strategy is deciding how much to commit and timing.

Value investors generally have the defining characteristic that they are risk-averse. Basically, they are willing to sacrifice some portfolio performance, if there is a sizable reduction in the associated risk. For this reason, long puts should be preferred over short calls by value investors, as the downside is very high with short calls – you can loose a lot more than the premiums received. The only time when it makes sense for value investors to use short calls is as a chance to initiate a short position at a future point at a higher price compared to the current market price – the strategy has the downside that assignment is not guaranteed but atleast the premiums will be yours to keep, if that scenario plays out.

Long puts are not a compatible strategy either for risk-averse investors as they represent capital at risk - one of the outcomes of such positions is the loss of all the monies committed to the strategy. So, value investors have to come to terms with this basic fact before committing monies. Given the risk-averse philosophy, it is best to aim to keep no more than a maximum of 2-4% of their total portfolio value invested in long puts.

Deciding on the timing aspect is more art than science. It is however vital as you stand to lose all the capital if what you foresaw plays out a few days/weeks after the expiry date of your position. It is a fool’s game to predict the exact timing of anticipated negative outcomes for a security price. Even when some anticipated event occurs, macro situations can drive the security in the opposite direction temporarily. Even so, chances of success are higher when positioning based on anticipated events/dates: earnings announcement, new product announcements, litigation result, regulatory approval, and favorable macro environment.

Moderately bearish strategies:

The Holy Grail with a long put position is almost unlimited upside. Long put positions can be altered to a moderately bearish position by using an opposite position that reduces the overall cost. The classic way to do this is using bear put spreads – it allows reducing the cost of a long put option position by using an opposite position that limits the potential upside. Reducing the duration of the contract will also reduce the cost but that is not usually possible - value investors need to incorporate a good margin for error in their estimate of the timing of the bearish scenario playing out.

The bane of short call positions is its unlimited downside risk. The bearish position can be altered to a moderately bearish position by using an opposite position that limits the downside risk. The classic way to do this is using bear call spreads – it allows reducing the downside risk of a short call position by using an opposite position that limits that downside.

1. Bear put spreads: Bear put spreads involve combining a long at-the-money (ATM) put position with a short out-the-money (OTM) put position (lower strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect sacrificing some potential upside of your short put position by collecting some premium upfront from a corresponding long put position that is far enough out of the money so that if you are assigned, you still exit with a very good profit. As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly optimistic of the company’s prospects for next quarter. So, you bought a put option on Google (GOOG) shares at a strike price of $600 for $30 (premium of $3000) expiring next month immediately after earnings. The analyst expectations shifted as the earnings date approached and the sentiment change resulted in the stock trading at $560 two weeks from earnings. At this point, you estimate the upside is now somewhat limited to $540 or so. A good way to reduce the cost of your original position at this point is by establishing a new short put position at a strike price of $540 at 20 (premium of $2000). In effect, you have managed to reduce the cost of your original long position from $3000 to $1000 while sacrificing the upside from the price dropping below $540. If the stock trades below $540 at expiry, your gains are limited but still very good: ($600-$540)*100-$1000=$5000. There is not much downside protection other than the fact that you reduced the risk capital from $3000 to $1000. The classic bear put spread strategy involves simultaneously buying ATM puts and selling OTM puts on the same security and expiration month, rather than waiting for a period of time to establish the latter position. The cost reduction will be lower when using that strategy as far-out-the-money puts will have very limited premiums associated with them.
2. Bear call spreads: Bear call spreads involve combining a long at-the-money (ATM) call position with a short in-the-money (ITM) call position (lower strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect reducing the downside risk by sacrificing some premium to purchase a protective call.  As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly optimistic of the company’s prospects for next quarter. So, you sold an ITM call position at $570 for $35 ($3500 premium) expiring next month, immediately after earnings –the idea is to keep the premium, when your bearish prediction plays out. The position has no downside protection. For example, if the stock spiked to $700 at expiry, you stand to loose a whopping $9500 (700-600-35), almost three times the premium received. To avoid this situation, you buy an at-the-money (ATM) call position simultaneously at $600 for $10 ($1000 premium). In this scenario, if the stock spiked to $700 at expiry, you loose only $500 ($9500 – $9000). The cost of reducing this downside risk was the call premium of $1000 you paid for the long ATM call position.

The bear spreads above are called vertical spreads as the strike price is used to implement the spread. A variation that uses the expiry to implement the spread is called calendar spreads. Longer term long puts are offset by short-term short puts.

Mildly bearish strategies:

Short positions represent a strong bearish stance on the company concerned. The strong bearish stance of a short position can be reduced to a mild bearish stance by selling puts. Out-of-the-money puts are preferred unless you think the stock price is already starting to tank. The put premium provides a small amount of downside protection. Also, out-of-the-money puts provide a way to exit the stock at a nice profit, if the stock goes down. There is no downside protection beyond the put premium realized upfront. Premiums go up as the time to expiration increase but chances of getting assigned also increase. Also, a series of shorter term option positions realize more premium income compared to a leap position of same duration and so in most situations going with shorter-term duration (three months or less) is the most beneficial when implementing this strategy.