The Short Side

By: Jon Najarian

The following is an excerpt from Jon Najarian's Dr J's Little Black Book

It is possible to play the short side of the market when you’re bearish on a stock, betting that the market will decline, or simply to protect your holdings, whether they are individual stocks or mutual funds.  This strategy is called the Put Spread.

Let’s say you’ve selected a stock after doing your homework, and you decide that the odds of the stock trading lower are greater than the odds of it trading higher.  One way to play your hunch would be to buy a put spread.  When buying a put spread, you lock both the maximum loss and the profit potential.  For example, on a 10-point put spread, the most you can lose is the amount you paid for the put spread.  But, the potential profit is the amount paid subtracted from the strike price differential.

For instance, if you paid $2.75 a share for a 10-point put spread, the maximum profit would be $10 minus $2.75, or $7.25 per spread.  Ideally, you want to have at least a 2-to-1 ratio.  That means for the times that you are right, you’re going to be rewarded at least twice as much as the amount you would lose when you’re wrong.  Adhering to this kind of ratio is the essence of risk control and money management.

Here’s an example of how a put spread works: Let’s say eBay is trading at $150 a share.  You decide to buy the $150 put and sell the $140 put, for a $10 spread.  If you pay $9 for the $150 put and sell the $140 put for $6.50, you would pay a net of $2.50 for a 10-point spread.  For one contract (equivalent to 100 shares), you would pay $250 per spread, which is also the maximum loss, and stand to reap a maximum profit of $750 per spread.

Now, even if eBay went to $200 a share – the exact opposite of what you wanted to happen – you would still lose only $250.  Overall, you are risking $250 to make $750 per spread, which is a three-to-one reward/risk ratio; which I would consider to be great odds in my favor.  And you are controlling the downside of what is otherwise a very volatile stock, which could be hard to borrow if you wanted to short it.  At the same time, you’d be in a position to profit handsomely if the stock trades the way you think it would and declines in price.

If eBay declines to $130 a share, you make a $20 profit on the $150 put, minus the $9 premium for a net profit of $11 a share.  The $140 put you sold is exercised, requiring you to buy stock for $140 when the stock is trading at $130.  You lose $10 a share, which is partially offset by the $6.50 a share premium collected, for a net loss on that trade of $3.50.  Your overall profit on such a spread trade is $7.50, or $750 per spread.

If eBay rises to $160 a share, the $150 put you bought expires worthless and you lose the $9 premium.  The $140 put you sold also expires worthless and you keep the $6.50 a share premium, for a total net loss of $2.50 a share, or $250 per spread.

An iron butterfly is more than just a reference to the 1960s heavy rock group.  An iron butterfly is a spread that allows you to profit from options on stocks or indexes that are trading in a range.  When you buy a stock outright, you’re speculating that the price will increase.  If that stock stays in a range – trading a little higher and then a little lower and then a little higher again – it’s tough to make a profit.  But with specialized spreads such as the iron butterfly, you improve your chances greatly of making a profit, especially if that stock continues to trade in a range.

Say, for example, you believe that during the month of April, which as we all know is the height of tax season, investors have significantly less capital to invest because they had to send money to Uncle Sam.  Even if you file for an extension, you still owe Uncle Sam cash on April 15.  With less cash on hand, there is less cash to invest in the market, which then tends to stagnate in April.  As a result, April is a time when the market normally trends in a narrow band, instead of rocketing up and down as it does in December and January (when it typically rallies) and October (when it usually sells off because of lingering fears of the crashes of 1929 and 1987).

In other words, times of the year that a given stock or index are likely to stagnate are perfect for doing iron butterfly spreads.

An iron butterfly is the simultaneous sale of a call spread and put spread, which result in a hedged short premium position that reaches its maximum profit potential if the equity or index stays in your predicted range.  Butterfly spreads are quite popular with index option trades.  Let’s use the S&P 500 Index as an example.  Among the S&P 500, 20 stocks are up, 20 stocks are down, and 440 are just about unchanged.  That means the S&P index is going to trade in a band.  Plus, the diversification within that index, across a spectrum of industries, tends to work in favor of the premium seller during times of low volatility.

Let’s say the S&P 500 Index is trading at 1450.  You believe it will trade between 1430 and 1470 – up and down 20 points from where it is currently.  You could sell the 1470 call for $8 and buy the 1480 call for $6 to protect it.  In effect, you’ve sold a 10-point call spread (the differential between the strike prices) for a net of $200 per contract.

For the downside end of the range, you sell the 1430 put for $7.00, and buy the 1420 put for $5.  You have sold a 10-point spread, again for $2.  With these two spread trades, you have bracketed the market just above and just below where you think it will trade, and you’ve collected a net of $4 in premiums.  The most you could lose on this butterfly spread is the difference between the net of $4 in premiums received and the $10 spread value, or $600 per contract.

Now, assume that the S&P fails to stay in your projected range and instead drops to 1400.  The 1420 put that you bought is now worth $20.  The 1430 put that you sold is now worth $30 to the buyer.  Your exposure on that trade is that you owe $10 per contract.  But that’s offset by the $4 in premiums that you collected, so your loss on that trade is cut to $6 per option.

If the market stays in the range that you projected – in this instance between 1470 and 1430 – then all the puts and calls expire worthless, and you are able to keep the $4 in premiums.  The maximum loss of $6 and potential profit of $4 is just under a 1:1 risk/reward ratio.  While that’s short of your optimal ratio of 2:1, it is not as skewed toward a higher loss than some other spread trades.

One reminder: S&P index options are European-style options; which means they are only exercisable at expiration, which makes them very popular.

For stock options, which may be exercised any time up to and on the day of expiration, the iron butterfly is a strategy that I like to use when a stock is in a range, such as right after earnings.  If Cisco Systems has just announced earnings and there is no big trade show or other potential news-making event, then I know most of the information – good or bad – is probably about Cisco.  That makes it a good time to look at establishing an iron butterfly spread.