How to Hedge for Uncertain Times

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Fed Chairman Ben Bernanke recently described the economic outlook as "unusually uncertain," and that's likely an apt description of what many investors are feeling.

Clearly, the U.S. economy is at a stimulus crossroads, threatened by a precipitous rise in personal savings, peaking corporate profits, and mounting systemic financial stress. Meanwhile, the S&P 500 is far from cheap by historical standards.

On the other hand, cyclical companies Caterpillar (NYSE: CAT  ) and Boeing (NYSE: BA  ) have recently reported increased demand, arguably reflecting the relative strength of global economies, as well as pockets of U.S. confidence.

Ultimately, while there's a sound argument for staying invested in particular stocks and industries, you'd have to be half-crazy to not at least be thinking of hedging against broad market declines.

And that's where the bear put spread comes in.

Tapping your inner grizzly
An options-based strategy, the bear put spread enables investors to profit from a move down in a particular stock, index, or exchange-traded fund, all while capping potential losses and gains.

First, recall that a put gives the options holder the right to sell the underlying security at a specific price (the strike price) up until a specific date (the expiration date). Accordingly, the put rises in value as the underlying security's price declines. Buying a put, then, is similar to taking a short position, only your potential loss is both limited and defined in advance, unlike the 200%-and-greater losses that can come with shorting common shares.

Unfortunately, buying a put outright can be expensive, particularly when market uncertainty is high. Ironically, this is likely to be the precise moment when investors are most in need of portfolio protection.

For example, the SPDR Trust (NYSE: SPY  ) ETF, which tracks the S&P 500, is trading above $111. If you believe that the market will turn once the excitement of second-quarter earnings recedes, you might consider the $110-strike September put, which, as I write, is changing hands for $3.35 per SPY share. An investor who buys that put with no price offset would need the SPDR Trust to fall below $106.65 -- 3% beneath the $110 strike -- to make a profit, and that's before commissions. This is where the options spread enters as an attractive alternative, enabling investors to achieve an outsized percentage return on a smaller capital outlay.

Spread on the gains
Similar to the bull call spread, the bear put spread involves both buying and selling an equal number of options contracts with identical expiration dates but different strike prices. The premium collected from the written, or sold, option -- in this case, the lower strike contract -- helps offset the cost of the purchased option.

Going back to our SPDR Trust example, one could buy the $115-strike put for roughly $5.75 and sell the $110-strike put for $3.35, bringing the pre-commission cost of the spread to $2.40. As with any vertical spread, the maximum profit is the difference between the two strike prices minus the cost of implementing the spread. In this scenario, that's $2.60.

The maximum loss, conversely, is what you pay to set up the trade. For our purposes, this would occur if SPY were trading above $115 (the higher strike) at expiration.

A few notable points about this spread. First, the upfront expense of $2.40 is less than the $3.35 it'd cost to simply buy the $110-strike put. Second, the spread is profitable as long as SPY is below $112.60 at expiration -- a far cry from needing a share price below $106.65, as is the case with the straight-up put purchase described above. Finally, as long as SPY is at or below $110 when the contract expires in September, the spread holder would collect the maximum $2.60 in profit on a $2.40 outlay, for a 100%-plus gain.

Not bad, eh?

Getting aggressive
Now, say you're so bearish that you're growing claws. In such case, simply set up a put spread with both strike prices below the current share price. Specifically, the $110-$105 SPDR Trust spread would cost about $1.44 to initiate and pay a maximum profit of $3.56, or nearly 250%!

Or, you may see the broad market moving sideways but spy weakness in certain sectors. In that case, you might consider economically sensitive industrial names such as U.S. Steel (NYSE: X  ) or Walter Energy (NYSE: WLT  ) as candidates for bear put spreads. Or a company such as Garmin (Nasdaq: GRMN  ) , which is operating in a structurally challenged industry. Highfliers that sport lofty valuations are also prime targets. Here, I'd look no further than MercadoLibre (Nasdaq: MELI  ) , which is trading at a trailing price-to-earnings ratio of 77 and a forward P/E of 43.

Doubly right
The justified criticism of options strategies is that you have to be right about both direction and time frame. In our first scenario, if the SPDR Trust eventually falls to $110 but not until November, that wouldn't be much consolation to the investor who was holding a September-dated spread.

Even so, the potential percentage gains and relatively small capital outlays make the bear put spread an attractive instrument to add to your investing tool kit.

MercadoLibre is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Mike Pienciak is short common shares of the SPDR Trust but holds no financial interest in any other company mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (3)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 28, 2010, at 2:12 PM, Glycomix wrote:

    Good article Mike. I'll paper-trade your option suggestion and see if it makes money. Once I understand options better, I'll try the ideas out.

    You are right. It's hard to make money buying and holding. P/E's are too high for value investing except for problem companies. As you point out, Garmin is highly undervalued, why buy a technology that may disappear? Who will buy a $300 GPS system when an iphone will do the same thing for no extra cost? Someone's bound to figure out a way to make the iphone emulate a GPS system in a plug-and-play fashion.

    When the stock market's too unpredictable, we can make money in options. Uh, we don't understand options, the bull and bear call spread. You're having to educate us in options in eye-dropper doses to overcome rejection of the unfamiliar.

    It's the Martha Steward dilemma. You have to explain the concept so simply that anyone could do it. Then show us HOW to put on a "bull call spread" and make money. Clearly briefly and simply explain the concept and how you implement it . That's incredibly hard.

    Martha's a broker. Perhaps she could explain options in teaspoon doses? That ability is why she's reputedly worth hundreds of millions. If you can explain options as clearly as she explains craft projects, you to will be worth that millions.

  • Report this Comment On July 28, 2010, at 2:16 PM, Glycomix wrote:

    Sorry. Had an attack of Mrs. Malaprop disease in the last sentence.

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