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Bear Spreads
The Smart Profits Report: Issue #197
Tuesday, April 5, 2005
Bear Spreads: Totally Risk-Free Profits Shorting Crude Oil
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
A few weeks ago in my trading service, we shorted crude oil using the Energy Select Spyder and exchange-traded fund XLE (AMEX: XLE.)
The XLE is a composite of gas and oil refiners, producers and explorers. It was a timely short. Oil prices fell almost 10% during our holding period. That was enough to return 30%-plus on our put position.
However, that is not the real story. The real story is how we turned an 8% drop in oil prices into a free lunch: a rare bear spreads trade opportunity in which we literally had zero downside risk, with nice upside potential.
And such opportunities will arise in the future. You just need to know how to recognize them and, once you do, you need to pounce…
Let me explain…
The Art of the Bear Spread
All our lives we have heard that there is no such thing as a free lunch. For the most part that is true. So, when we do get a chance at a free lunch, we should take it. And that is what many of my subscribers did.
Last week I issued the following recommendation to my readers:
- Take your profits of 30%-plus on the position…
- Or enter into a bear spread.
I would say, judging by the volume, that it was about 50/50 between those who took profits and those who engaged in the spread.
Here is how the spread worked…
We started with a simple trade. We bought the $39 strike LEAPS put on the XLE for $2.45. This option gave us the right to be short the XLE at $39 until expiration in 2007. If oil prices went down over the next two years, we would make money.
Fortunately, oil prices went down sooner than expected, and as I have mentioned before, the power of LEAPS is that they exaggerate the moves that the underlying security makes in your direction in the short term. Hence the 30% gain on our option from an 8% move in the ETF.
Going Back for Seconds
Because the XLE moved down so rapidly, this trade was ripe for extending into a bear spread. To do that, we would keep our initial LEAPS put and sell another one at a lower strike. I looked at the other options that were available. It turns out that the $37 Put LEAPS with the same 2007 expiration was trading for $2.55 on the bid at the time of the recommendation. I scrambled to get the play out - knowing how volatile the market for oil is.
We ended up selling the $37 option against our $39 option, and received at least $2.45 for our effort. Some of my subscribers did even better. But when we received that $2.45 from selling the $37 put, it was a return of our initial $2.45 invested in buying the first put at $39.
That left our amount at risk at ZERO. This means that in the worst-case scenario - if oil goes to $100 a barrel and the XLE soars to $75 instead of falling as we hope - even if we hold the position until expiration, we still will lose nothing, nada, zilch. We can be completely wrong and not lose a dime.
And if we are right, it’s all free money.
Now, if oil were to fall as we are betting it will - say to $45 per barrel at expiration two years from now (or before then) - we could cash out the option.
Breaking Down the Bear Spread Numbers
Here’s how this would work if we held until expiration and oil prices were lower in January 2007 then they are today.
The put we sold at $37 would surely be in the money, and we would have to meet our obligation to buy XLE shares at $37. But we own the right to sell the XLE at $39 per share - because of the $39 put that we bought.
So, we’d buy shares at $37 and sell shares at $39, for a gain of $2 per option if the XLE were to close at $37 or lower at expiration.
Actually, anything below $39 would make us money - but our gain would be limited to $2 ($39 minus $37) when the XLE falls to $37 and lower. Our at-risk money is $0.00 - you can figure out the return on your money at risk if we win!
Now, if oil prices go up and the XLE follows, we will make nothing… but we will lose nothing either.
We have done many bull spreads in the past, but this was the first bear spread we engaged in. Most often a bear or bull spread is entered into at the beginning of a trade. However, we turn trades into spreads after we have a confirmed profit in our original position, most of the time. That’s a way to mitigate risk substantially while maintaining a VERY healthy upside for profits.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Hang onto your hat, because we’re going to dive headlong into the low-risk, profitable world of option spread trading today - both bear spreads and bull spreads. The mere mention of terms like these can intimidate some investors and dissuade them from making the trade. Don’t be one of them. You’d be missing out on a great, low-risk way to grab profits, so check out Smart Profits #330, Option Spread Trading: How a Bear Spread Can Make You More Than One Put Options Trade.
- While it might seem odd that you don’t have to be right on your market call in order to still enjoy a winning trade, hear me out… because today, I’m going to give you one of the best options strategies that relies more on picking where the market won’t go, rather than where it will go. Interested? If so, check out Smart Profits #348, Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win.
- One of the core principles that separates the top traders from the mediocre ones is the need to take responsibility for all their trading-related actions.We must take responsibility for our own investment performance. And if you want to enjoy bigger, more consistent profits, this means making some real changes in the areas that matter most. So take some time to read Smart Profits #389, Improve Your Investing Results: Your 8-Step Checklist To More Successful Investing.
Related Articles:
- Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
- Spread Trading: Lower Your Cost And Hedge Your Risk In One Profitable Bull Spread Trade
- Bull Spreads: Bagging a 66% Return on Lexar
