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.

Short Selling vs Long Puts – Strategies for Value Investors

Long puts are bought on the expectation that there is a good chance for the stock to go down in the short-term, allowing the investor a chance to profit from that directional outcome. The maximum upside occurs if the stock price drops to zero before expiry. The maximum loss on the other hand is limited to what is committed upfront – the option expires worthless should the stock price stay above the strike price before the expiry date.

Short selling on the other hand involves borrowing the shares and selling upfront. The expectation, similar to a long put, is to make a profit from the downward directional move of the concerned stock. The difference is that it is not time limited i.e., the position will stay intact until closed. The short sale proceeds are credited to one’s account – paying the dividends is one’s responsibility. The key downside is the unlimited potential loss - there is no theoretical limit to how high a stock can go and hence there is no limit to ‘how much’ one can lose, should the stock price march higher.

Long put positions can prove beneficial to value investors in the following situations:

1. Say you own a stock XYZ at $30 per share. The price has since moved up to $50 and you still consider it a good value. However, the macro situation has changed and your analysis indicates the possibility for a sharp temporary pullback. In this scenario, buying protective long puts is a good strategy to earn additional income - should the stock drop, the puts increase in value.
2. End of year tax considerations can lead to a situation where a stock might not be sold even though all analysis point to selling as the right strategy. Here also, buying long puts as part of a collar construction can ensure that profits are locked in.
3. In situations when your fundamental analysis strongly indicates that a particular stock is way overvalued, committing a small amount of capital using long put positions is a good strategy to benefit from a probable pullback.

Short selling can be beneficial to value investors in the following situations:

1. Some value investors attempt to construct a portfolio aimed at generating absolute returns – the purpose is to generate positive returns year after year, independent of overall market direction. A long-short approach is one way to arrive at such a portfolio – hold both long and short positions although on the average, one or the other sets of positions will be more, depending on the macro assessment. The aim is to profit from all directional moves the research indicates, rather than attempting to benefit only on the long-side.
2. If the fundamental analysis of a particular stock has shown with a high degree of confidence that impending bad news (financials are questioned - fraud, SEC inquiries, pending lawsuits, etc.) will cause the company’s stock price to plummet, short selling such stocks is a good strategy to profit from the expected outcome.  In such scenarios, you cannot predict the timing and so long puts are not a good option.

Tracking David Einhorn's Greenlight Capital Portfolio: Q1 2012 Update

Below is a spreadsheet that highlights David Einhorn's moves this quarter. Please check-out our SeekingAlpha column for an analysis of the moves:

Basic Options Strategies for Value Investors

Options are an excellent tool for value investors. Value investors who rely on Fair Value Estimates (FVE) to arrive at Buy/Sell decisions tend to use a two-pronged approach:

• Bottom-up fundamental analysis, and
• Macro considerations

Rather than using a fixed FVE, value investors rely on a range of FVE’s based on the assumptions and methods used. With a range of FVE’s in place, the Buy decision can be based on a margin-of-safety around the low-point of the FVE’s and the Sell decision when the market value approaches the FVE.

Macro environment can cause the overall market to stay significantly undervalued or overvalued for extended periods of time. In times of market undervaluation, it is easier for value investors to stay fully invested while the reverse is true during periods of significant market overvaluation. Hanging on to cash under such circumstances can result in value investors missing out by a long chalk as cash holdings rarely provide significant returns. This, in essence, is the bane of long-only value investors.

Value investors would be better off with a long-short portfolio instead of one laden with longs only. Then, value investors can opt to stretch their short-portfolio when the macro picture indicates the overall market overextended and shrink the same when the macro points to the contrary. The approach is not without downsides: 

a)      Open-Ended Risk: The losses can be limitless while the returns are capped as the stock cannot dip beyond zero. For e.g., the maximum profit from shorting 100 shares of a $50 stock of ABC is 100% of the proceeds received when shorting ($5,000) – realized if the stock goes to zero. On the other hand, if the stock goes to $150 and the decision is to close the position, the loss is 200% of the proceeds received when shorting ($10,000) – theoretically, the losses have no limit as there is no ceiling for the stock price of a company.

b)      Costs: Several expenses are associated with shorting stock - the fees the broker charges for borrowing the shares, dividend payment on short position, and margin costs. A part of the cost may be offset if interest is earned on the short proceeds. The cost increases as the position is held for extended periods of time.

Options based strategies are a valuable tool for value investors. Below lists some of the most basic option strategies that can be employed:

a)      Short Puts: Short puts involve selling put options on a stock at a particular strike price. The expectation is that the stock will stay above the strike price during the option period allowing one to pocket the premium realized as pure profit. But, one is obligated to buy the stock, if and when assigned. Hence, it is best to write cash-covered puts – meaning one has the liquidity to buy the stock at the strike price. Short puts are a way for value investors to potentially enter a stock at a price they wish to enter. For e.g., say the FVE indicates stock ABC is a good value at $30 or below and the stock is currently trading at $35. An option in this scenario would be to sell put options on ABC at $30. If the stock stays over $30, the investor gets to keep the premium received. But, if it went below $30, most probably the stock would be assigned and the investor would own the shares at $30. The downside is the value of the position at the strike price, if the option was assigned. For this reason, it is best to view short put positions as though one is long on the stock at the option strike price in an amount equal to the contract size – if the sale were for 5 contracts, assume one is long 500 shares.

b)      Long Puts: Long puts involve buying put options on a stock at a particular strike price. Though the put premium needs to be paid out, it provides protection, if the investor owns the underlying shares. For e.g., say one has ownership of a stable stock XYZ at a cost-basis of $25. The stock is currently trading at $50 and the investor still thinks there is a good margin-of-safety at the current price. But, since the stock has gone up, there is an urge to protect the gains. In such a situation, long puts are value investors ally. It provides a way to protect the gains against a stock decline for the price of the premium, while keeping the upside intact.

c)      Short Calls: Short calls involve selling call options on a stock at a particular strike price. The expectation is that the stock will stay below the strike price during the option period, thereby allowing the investor to pocket the premium realized as pure profit. But, the investor is obligated to give away the stock at the strike price, if assigned. Hence, it is best to write covered calls – meaning one is long the underlying stock in an amount equal to the contract size – if selling 5 contracts ensure one is also long 500 shares. For value investors, short calls allow a way to realize periodic income on a stock. The strategy can be used against one’s long positions when the overall market and the stocks involved are fairly valued or over-extended. One is spared from selling the stock as it is unclear how long the macro situation will prevail. In this scenario, using covered calls help realize periodic income, embellishing one’s returns.

d)     Long Calls: Long calls involve buying call options on a stock at a particular strike price. The expectation is that the stock will go well above the strike price during the option period, allowing one to realize potentially huge profits in a short period of time (option period). Should the stock stay below the strike price, the call premium is lost. Value investors can apply this strategy with stocks that have a chance to go up significantly over a short period of time, should an anticipated event occur. For e.g., say the stock of a company, known to have a history of blowing past earnings expectation once every few quarters, is trading at $100. Research has narrowed down on the fact that the coming quarter is one of those quarters. In this situation, value investors can opt for long calls covering the quarterly report at a strike price of $100 for say $10. If the stock moves as expected to $130 immediately after the earnings release, the money invested have tripled. On the other hand, if the investor were to go long the same amount of shares at $100, the returns would have been just 30% following the quarter report and stock move.

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Last Updated: 04/2012.

Short Selling Strategy for Value Investors

The perils of short-selling can be summarized in a simple statement: “Upside is limited to 100% but downside is unlimited”. Some of the famously successful short-sellers such as George Soros are known to use strategies that limit the downside risk to less than the size of the initial short position while increasing the upside potential over 100% by using variations on the following strategy:

1. Set up stops at higher prices to close parts of your position, if the stock moves against you. The amount to close should be such that the size of the position remains at ~1%.
2. Set up entry points at lower prices to add to your short position, if the stock goes down. The amount to add should be such that the size of the position remains at ~1%.

An example follow:

1. Say your portfolio size is $100K and you want to start a 1% short position on XYZ stock priced at $10. So, you short 100 shares at $10.
2. If the stock doubles, close the short position and your loss will be $1K, or 1% impact to your portfolio. So, your losses are capped at 100% of your initial position. The same strategy can be used to close parts of the position at more granular points rather than waiting for the stock to double before closing. That can reduce the downside risk even more. In our example, if you dispose 50% of the position when the stock increased by 50% ($150) and disposed the rest when the stock doubled, your total loss is 75% of your initial position.
3. If the stock drops 50%, increase the short position so as to keep the size of the position relative to the portfolio size constant at 1%. This ensures that the portfolio impact will be more than 1%, or more than 100% of your initial short position. In our example, if the stock drops by 50% to $5, sell short another 100 shares so that the size of your short position remains at 1% of your portfolio (200 shares * $5 = $1K or 1% of your portfolio of $100K). At this point, you netted a total of $1.5K by selling short the 200 shares. Now, if the stock goes to zero, your profit would be $1.5K or 150% of your initial short position for a 1.5% overall portfolio impact. The strategy can be used in a more granular fashion to increase the return potential even further.

Related Posts:

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Last Updated: 04/2012.