Is The Bear Here?

Is the bear here? Have six years of solid yields in the stock market going to be wiped away by a massive correction? Should you be worried?

I have no idea, but I’m prepared to a certain extent whether or not a bear yields its ugly face. You can do the same, as long as you are approved for options trading.

 

Strategy #1: Make sure you have put options covering or exceeding the amount of shares you have in companies – for example if you are holding 100 shares of Apple which is worth around $106.25 after falling almost 7% in the past five days, you should hold at least one put option of Apple. The strike price for the put option is where a lot of the magic comes into play, as if you buy a put option with a strike price above Apple’s current market value you are making a very conservative play that will be handsomely rewarded if Apple stock price falls but costs a moderate amount more than an option with a strike price around $100 for example.

In my real-price example I will use the March 20th, 2015 expiration date. The Put option with strike price of $110 (above the market price of AAPL which is $106.25) costs $850. The put option for $100 costs $370. The difference is $480, which is less than the difference in share price for a given options “basket” which is $625. That means that It makes more sense to buy the more expensive put option if the stock falls, because even if it falls past the lower strike price you will be making more money.

Let’s say Apple falls to $90 per share by March 20th – with the more expensive put option you make $20 per share in your basket minus the commission which comes out to a profit of $1150. If you had purchased the cheaper lower strike price option you would make $630. Of course you stand to lose more if Apple goes up by March with the first option, which is why options being supported by a long ownership of Apple makes sense.

Strategy #2: Short the stock market. Sell  shares of a company you don’t own with the intent of buying them back later at a lower price. This is a highly risky strategy as shorting a stock makes you liable to pay any dividends they issue from your account and without a call option to secure the short position the loss potential is astronomical. One company that is heavily shorted is Herbalife Ltd., which some hedge fund managers consider to be a pyramid scheme soon to be busted by the government. If you short the stock market you will make money in a bear market.

Strategy #3: Sell all of your stocks and invest in corporate bonds or bank CDs. This is sort of like giving up on high yield investing, find a bond that suits your risk level or go with a municipal bond that may offer tax savings at the state level. Even more risk averse you can put money into T-Bills, which is what countries like China have done to protect the value of their huge cash surplus.

Locking In Gains with Put Options

Are you too scared to sell the stocks that have made over 50% in the past year or two? Is it because you want to hold off on cashing in and paying a heft amount of capital gains tax? How about doing what the big banks do, buy put options! Put options go up and make money if the price of a stock goes below a certain amount by a certain time. That means if you buy put options for your most profitable stocks you will be essentially locking in profits while not having to sell these stocks which might be paying dividends.

The downside with put options is you must pay a price to buy the put option from an available seller and put options expire based on what their expiration date is. The longer the expiration on a put the more expensive it will be. Let’s say you were lucky enough to be able to purchase Alibaba at IPO pricing – $68 per share. Currently BABA trades at $106, so you’ve made $38 per share, not too shabby. However, you foresee or have fear that BABA may fall below $100 and want to make sure you lock in those profits while not making a short term sell. What you can do is buy put options to cover your stocks until October 2015. Or if you want to save some money you could also buy put options now to cover you until March and then re-evaluate your “options”.

Options are cheaper than their underlying security because they are worthless if they aren’t “in the money” when they expire – to understand these options concepts if your a newbie please read this, this, or this.

What’s a Bull Spread?

A bull spread is a type of call option that aims to profit off of a underlying security that has a specified percent increase. Most of the time investors aim for moderate or low price increase.

An example of a bull spread is to buy a call option for Apple for a expiring three months from now for a strike price of $130 per share. Apple trades at $113.99 as of right now (premarket 12/29/2014). The call option costs $1.37 market price, so for a single option you will be paying $137 (options come in stacks of 100). If you wanted to lower that cost all you’d have to do is sell another call option for Apple for say $140. You’ll get 50 cents for this, so you’ll lower your total cost for this “play” to 87 cents. So pay $87 rather than $137 to make at MOST $10 per share, or $1,000.

I personally am not a fan of the bull spread because of the fact that you’re limiting your winnings, it’s like buying insurance on your winnings. I must prefer having unlimited UPSIDE potential with a put option in place as INSURANCE. Even so, when you’re hedging your investments you are limiting your profit potential.

You can also do what I call a “bear spread” by buying a put option and then selling a put option for a even lower strike price. This would be in anticipation for a moderate downfall in the price of an underlying security. I would personally never do this, it would almost take a wizard or oracle to predict such a price fall to such a degree. You’re better off shorting a stock then paying such hefty premiums for these options.

If you’re interested in seeing what a bull spread looks like on a profit-loss graph here it is below:

Call option March 20 leg 1 buy $130, leg 2 sell $140

Call option March 20 leg 1 buy $130, leg 2 sell $140