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Back in August, we checked out an option strategy called a “collar.” It enables stock owners to protect themselves from a potential fall.

If you recall, it’s a two-pronged strategy. First, buying a put option gives you the right to sell your shares at the option’s strike price at any time until the option’s expiration.

To help fund the purchase of the put option, the second part of the strategy involves selling call options on the underlying stock. If you play it right, you can generate a credit from the strategy.

Today, though, I want to look at a variation on this theme…

A collar strategy helps protect shares you already own. But what if you don’t own the shares – yet still want to profit from a potential fall? And better still, you want to do it at a fraction of the cost of buying a put option.

That’s where today’s strategy fits into the picture…

The “Buying” Leg

To begin, let’s consider buying a put option. A put option increases in value when the underlying asset falls.

By paying just a few hundred dollars, for example, you can control 100 shares in a stock that you think is going to fall (an option contract is for 100 shares).

But you can take it a step further. If you get things right, you can effectively buy that option for free. And that’s where the second part of the strategy fits into the picture…

By placing a “spread” trade to generate a credit, we can offset the cost of buying that put option.

The “Selling” Leg

To see what I mean, let’s consider an example using the SPDR S&P 500 ETF Trust (SPY). And please note that this is an example, not a recommendation.

With SPY trading at around $665, you believe it could be headed for a fall. So you look at buying a $650 put option for around $3. (That equates to $300 out of pocket per contract since an option contract is for 100 shares.)

To help you finance the trade, you sell a “bear call spread.”

A bear call spread involves selling a call option while simultaneously buying a call option with a higher strike price. Both options have the same expiration. The bought call is like insurance, protecting you if the stock price rallies strongly.

In this instance, selling a $670 call option generates a $5 credit, while a $680 call option costs you $2 to buy. So altogether, the bear call spread generates $3 (or $300 per contract).

Take a look at the chart…

SPDR S&P 500 ETF Trust (SPY)

Source: eSignal

In this example, the $300 from selling the bear call spread covers the $300 cost of buying the $650 put option.

This effectively lets you enter the put trade for free.

But you need to understand that there is still some risk associated with the trade. And it revolves around the bear call spread…

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Know Your Risks

When you use a bear call strategy, you’re aiming for the stock price to be trading below the lower leg at expiration ($670, in this case). That way, you generate the maximum profit from the spread trade. In this example, that’s $300.

However, if SPY rallies above $670, the trade begins to move against you. And if SPY rises above the upper leg of the spread ($680), you’re facing a maximum loss scenario…

The max loss is calculated as the difference between the call option strike prices ($680 – $670 = $10), less the credit received for the trade ($3). That works out to $7, or $700, on a one-contract basis.

Plus, in this case, you’d lose the money from your put trade ($300), since you’d no longer have the credit from the spread trade to offset the cost.

As you can see, you need to be confident of the down move before committing to the trade. (Bear in mind that you can always close out the position if it starts going against you.)

Yet if you get it right, this strategy effectively allows you to gain access to a down move with no out-of-pocket cost. It also highlights the great versatility of options.

And with October historically a volatile time for stocks, it could be a great strategy to put in your toolbox.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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