The Value Line Daily Options Survey

Consider the Bear Spread Hedge

This week, we show how you can hedge your stocks with a bear spread. These days there is a tendency for higher strike options to be underpriced and lower strike ones to be overpriced. This set of conditions can create many attractive bear spread opportunities as we will show with examples on the following rank 1 stocks; Apple Inc. (AAPL) and Express Scripts (ESRX). The latter hedge was even established at a credit with time decay in favor of the investor.

The Basic Bear Spread

A basic bear spread consists of buying a higher strike option and selling a lower strike one with the same expiration. You can construct this spread with calls or puts but not calls and puts in the same spread. A bear spread constructed with puts is called a bear put spread, while one constructed with calls is called a bear call spread. When you create a bear put spread, you pay a net debit of premium since you are buying the (higher strike) higher premium put and selling the (lower strike) lower premium put. When you create a bear call spread, you receive a net credit of premium because you are selling the (lower strike) higher premium call and buying the (higher strike) lower premium call. Without owning the underlying stock, the bear call spread is a credit spread and subject to a margin requirement (equal to the difference between the long and the short strike prices minus the net premium received). However, when you use a credit spread as a hedge against shares that you own, you are not subject to any margin. This is because the total position is viewed by the exchanges as a combination of a covered call (long stock, short call) and a long call.

As we often stress, options are insurance. When you hedge with a bear spread, you are buying insurance with the option purchased and selling insurance with the option sold. In effect, you are capping off your coverage beyond a certain level of possible losses in the stock. (Similar caps in coverage exist in many homeowner, health and auto insurance policies.)

In Graph 1, we show an example of a rank 1 stock, Apple Inc. (AAPL), hedged with a bear put spread with the stock at $158.76. In this example, we have bought the near-themoney October $160 put for $10.35 and written the out-of-the-money October $140 put for $3.20. For this hedge, we paid out a net debit of $7.15 per share or $715 for hedging 100 shares. Compare this with spending $1035 for hedging with the $55 put alone. According to our model, the Estimated Normal Price of this spread was $770, so on a net basis the hedge was underpriced.

This graph shows different outcomes for this hedged position at different stock prices on three different dates; (1) the day the hedge was established (7/29/09), half way to expiration (9/07/09) and at the October expiration date (10/17/09). Looking at the graph, we can see that at expiration if the stock ends up at $140, our loss will be only $353. Compare this with the $1,886 we would have lost if we hadn’t hedged at all. If we had hedged with just buying $160 put alone, our loss would have been a little more than $705 ($1,886 loss in the stock minus a net profit of $1,181 on the $160 put). Of course, if the stock were to make a much larger fall, you would be better off having hedged with just the $160 put.

Does it make sense to cap your insurance in this manner? Often it does, provided you believe that, over the life of your hedge, the risk is limited. All too often, the “gut” reaction to a risky situation is to buy nominally cheap out-of-the-money insurance. In the above example, if you had hedged Apple by buying the $140 put and the stock ended up at $140, you would have been worse off than having not hedged at all since you will have paid the premium and had no coverage against your loss. It is much more cost effective to hedge your exposure in accordance with your reasonable expectations of what the outcomes might be.

In Graph 2 also on page 3), we show Express Scripts (ESRX) hedged with a bear call spread. In this example, with ESRX at $71.62, we have written the in-the-money (lower strike) November $65 call at $9.30 and, to give us some upside, we have also bought the November $80 call at $2.10. This spread gave us a net credit of $7.20 per share, which is wider than our model’s estimate of $6.60. Thus, according to our model, this spread is favorably priced. Notice in the graph that as long as Express Scripts ends up above $65, the investor will have made a small $58 profit at the November expiration. The investor also gets to reap pretty decent gains if the stock makes appreciable gains above the $80 level. The investor can reap short-term gains in the hedged position. That is because, at present, the combined position has a positive net delta of 55.35 or $3,964 in dollar terms (i.e., .5535 times the stock value of $7,162).

Other Reports in our Reports Archive on Hedging and Spreads

Stocks Hedged with Collars, Ot09079.Pdf

Buying Protective Puts, Ot090209.Pdf

Basic Bull and Bear Spreads, Ot070813

Prepared by Lawrence D. Cavanagh
vloptions@valueline.com