A subscriber wrote in and asked what he should do if he thought the market would be 6% lower by the end of September. I thought about his question a little bit, and decided to share my thoughts with you, just in case you have similar feelings at some time along the way.Terry
5 Option Strategies if you Think the Market is Headed Lower
We will use the S&P 500 tracking stock, SPY, as a proxy for the market. As I write this, SPY is trading just below $210. If it were to fall by 6% by the end of September (3 months from now), it would be trading about $197 at that time. The prices for the possible investments listed below are slightly more costly than the mid-point between the bid and ask prices for the options or the option spreads, and include the commission cost (calculated at $1.25 per contract, the price that Terry’s Tips subscribers pay at thinkorswim).
#1. Buy an at-the-money put. One of the most common option purchases is the outright buy of a put option if you feel strongly that the market is crashing. Today, with SPY trading at $210, a September 2015 put option at the 210 strike would cost you $550. If SPY is trading at $197 (as the subscriber believed it would be at the end of September), your put would be worth $1300. You would make a profit of $750, or 136% on your investment.
Buying a put involves an extremely high degree of risk, however. The stock must fall by $5 ½ (about 2.6%) before you make a nickel of profit. If the market remains flat or goes higher by any amount, you would lose 100% of your investment. Studies have shown that about 80% of all options eventually expire worthless, so by historical measures, there is a very high likelihood that you will lose everything. That doesn’t sound like much of a good investment idea to me, even if you feel strongly about the market’s direction. It is so easy to get it wrong (I know from frequent personal experience).
If you were to buy an out-of-the-money put (i.e., the strike price is below the stock price), the outlook is even worse. A Sept-15 205 put would cost about $400 to buy. While that is less than the $550 you would have to shell out for the at-the-money 210 put, the market still has to fall by a considerable amount, $9 (4.3%) before you make a nickel. In my opinion, you shouldn’t even consider it.
#2. Buy an in-the-money put. You might consider buying a put which has a higher strike than the stock price. While it will cost more (increasing your potential loss if the market goes up), the stock does not need to fall nearly as far before you get into a profit zone. A Sept-15 215 put would cost you $800, and the stock would only have to fall by $3 (1.4%) before you could start counting some gains. If the market remains flat, your loss would be $300 (38%).
If the stock does manage to fall to $197, your 215 put would be worth $1800 at expiration, and your gain would be $1000, or 125% on your investment. In my opinion, buying an in-the-money put is not a good investment idea, either, although it is probably better than buying an at-the-money put, and should only be considered if you are strongly convinced that the stock is headed significantly lower.
#3. Buy a vertical put spread. The most popular directional option spread choice is probably a vertical spread. If you believe the market is headed lower, you buy a put and at the same time, sell a lower-strike put as part of a spread. You only have to come up with the difference between the cost of the put you buy and what you receive from selling a lower-strike put to someone else. In our SPY example, you might buy a Sept-15 210 put and sell a Sept-15 200 put. You would have to pay $300 for this spread. The stock would only have to fall by $3 before you started collecting a profit. If it closed at any price below $200, your spread would have an intrinsic value of $1000 and you would make a profit of $700 (230% on your investment), less commissions.
With this spread, however, if the stock remains flat or rises by any amount, you would lose your entire $300 investment. That is a big cost for being wrong. But if you believe that the market will fall by 6%, maybe a flat or higher price isn’t in your perceived realm of possible outcomes.
Another (more conservative) vertical put spread would be to buy an in-the-money put and sell an at-the-money put. If you bought a Sept-15 220 put and sold a Sept-15 210 put, your cost would be $600. If the stock closed at any price below $210, your spread would be worth $1000 and your gain ($400) would work out to be about 64% after commissions. The neat thing about this spread is that if the stock remained flat at $210, you would still gain the 64%. If there is an equal chance that a stock will go up, go down, or stay flat, you would have two out of the three possible outcomes covered.
You also might think about compromising between the above two vertical put spreads and buy a Sept-15 215 put and sell a Sept-15 205 put. It would cost you about $420. Your maximum gain, if the stock ended up at any price below $205, would be $580, or about 135% on your investment. If the stock remains flat at $210, your spread would be worth $500 at expiration, and you would make a small gain over your cost of $420. You would only lose money if the stock were to rise by more than $.80 over the time period.
#4. Sell a call credit vertical spread. People with a limited understanding of options (which includes a huge majority of American investors) don’t even think about calls when they believe that the market is headed lower. However, you can gain all the advantages of the above put vertical spreads, and more, by trading calls instead of puts if you want to gain when the market falls. When I want to make a directional bet on a lower market, I always use calls rather than puts.
If you would like to replicate the risk-reward numbers of the above compromise vertical put spread, you would buy a Sept-15 215 call and sell a Sept-15 205 call. The higher-strike call that you are buying is much cheaper than the lower-strike call you are selling. You could collect $600 for the spread. The broker would place a $1000 maintenance agreement (no interest charge) on your account (this represents the maximum possible loss on the spread if you had not received any credit when placing it, but in our case, you collected $600 so the maximum possible loss is $400 – that is how much you will have to have in your account to sell this spread). Usually, buying a vertical put spread or selling the same strikes with a credit call vertical spread cost about the same – in this case, the call spread happened to be a better price (an investment of $400 rather than $420).
There are two advantages to selling the call credit spread rather than buying the vertical put spread. First, if you are successful and the stock ends up below $205 as you expect, both the long and short calls will expire worthless. There will be no commission to pay on closing out the positions. You don’t have to do anything other than wait a day for the maintenance requirement to disappear and you get to keep the cash you collected when you sold the spread at the outset.
Second, when you try to sell the vertical put spread for $10 (the intrinsic value if the stock is $205 or lower), you will not be able to get the entire $10 because of the bid-ask price situation. The best you could expect to get is about $9.95 ($995) as a limit order. You could do nothing and let the broker close it out for you – in that case you would get exactly $1000, but most brokers charge a $35 or higher fee for an automatic closing spread transaction. It is usually better to accept the $995 and pay the commission (although it is better to use calls and avoid the commissions altogether).
#5. Buy a calendar spread. My favorite spreads are calendar spreads so I feel compelled to include them as one of the possibilities. If you think the market is headed lower, all you need to do is buy a calendar spread at a strike price where you think the stock will end up when the short options expire. In our example, the subscriber believed that the stock would fall to $197 when the September options expired. He could buy an Oct-15 – Sept-15 197 calendar spread (the risk-reward is identical whether you use puts or calls, but I prefer to use calls if you think the market is headed lower because you are closing out an out-of-the-money option which usually has a lower bid-ask range). The cost of this spread would be about $60. Here is the risk profile graph which shows the loss or gain from the spread at the various possible stock prices:
Bearish SPY Risk Profile Graph June 2015
You can see that if you are exactly right and the stock ends up at $197, your gain would be about $320, or over 500% on your investment (by the way, I don’t expect the stock will fall this low, but I just went into the market to see if I could get the spread for $60 or better, and my order executed at $57).
What I like about the calendar spread is that the break-even range is a whopping $20. You can be wrong about your price estimate by almost $10 in either direction and you would make a profit with the spread. The closer you can guess to where the stock will end up, the greater your potential gain. Now that I have actually bought a calendar spread at the 197 strike, I will buy another calendar spread at a higher strike so that I have more upside protection (and be more in line with my thinking as to the likely stock price come September).
There are indeed an infinite number of option investments you could make if you have a feeling for which way the market is headed. We have listed 5 of the more popular strategies if someone believes the market is headed lower. In future newsletters we will discuss more complicated alternatives such as butterfly spreads and iron condors.