Doubting this Rally? Hedge with these Bearish Option Strategies Part I

In the past week earnings have propelled the stock market to rally significantly. Since Tuesday July 14, 2009 the Dow Jones Industrial Average leads all major indices up 6.66%, NASDAQ is higher by 6.47%, and the S&P 500 has gained 5.38%. The question a lot of people have been asking is: Can this rally hold? To tell you the truth, I'm not sure what to think of it, but I have some hedges in place, for the next piece of ugly news that the market sells off on. With that being said, as I've stated 100 times in my blog OptionMaestro.com, there's still a ton of cash on the sidelines, getting extremely low rates. This rally could continue for quite a while as this money could be moved into the market.

This is part one of two, in this article I'll take the bearish approach on the market, and give a Bear Put Spread option idea on each component of the Dow 30. In part two I'll take a bullish approach on the market with a Bull Call Option Spread idea on each.

To understand this post you'll need somewhat of a background in stock options. To learn more about options including this strategy, how options can help protect your portfolio, and allow you to speculate with less money up front click here.

Why use the Bear Put Spread Option Strategy instead of plain old put options?

The reason I like selling the spread when hedging my portfolio is because it allows me to hedge for a cheaper premium, and although it gives me less downside protection, I believe it should protect the majority of the move lower if the market does correct in the month to come.

All data as of market close Tuesday July 21, 2009.

HOW TO READ THE TABLE

• Price - This is the closing price [last quote price at market close] of the security
• High - This is the higher strike price of the two Put option contracts, the one being purchased in my examples. To keep things simple I chose the option strike price closest to the closing price. Some strikes may be below current share price and some may be above.
  
• Low - This is the lower strike price of the two put option contracts, the one being sold in my examples. I took the strike at least 5% lower from the current share price.
• % Missed - This is how much the given stock will fall by before the higher of the two put options starts protecting your position. Stocks currently below the higher strike price do not have any % miss, as they are in the money.
  
• % Protect - This is how much protection the option spread protects your position. The difference between the high strike and the low strike, or current share price to low strike (for in the money examples).

The first stock listed in the table below is 3M (MMM), and is currently in the money. An example of the Bear Put Spread option strategy for 3M would be interpreted as:

Buy the 3M (MMM) August 65 put and sell the August 60 put. This position gives you protection of up to 6.54% [$4.20 per share] on 3M (hedges position down to 60 a share until August 22, 2009). This position is currently in the money by 80 cents ($0.80) a share which means % missed does not apply. This spread strategy would cost $190 per contract to open, versus $265 for each August 65 strike put option contract purchased.

Company	Ticker	Price	High	Low	% Missed	% Protect
3m Co	MMM	64.2	65	60	0.00	6.54
AT&T Inc.	T	24.57	25	23	0.00	6.39
Cisco Systems Inc	CSCO	21.59	22	20	0.00	7.36
Intel Corporation	INTC	18.9	19	17	0.00	10.05
International Business Machines	IBM	117.04	120	110	0.00	6.02
Johnson & Johnson	JNJ	59.49	60	55	0.00	7.55
JP Morgan & Chase & Co	JPM	36.94	37	35	0.00	5.25
Kraft Foods Inc.	KFT	27.58	28	26	0.00	5.73
McDonald's Corporation	MCD	58.63	60	55	0.00	6.19
Merck & Co., Inc.	MRK	29.65	30	27	0.00	8.94
Microsoft Corporation	MSFT	24.83	25	23	0.00	7.37
Pfizer Inc	PFE	15.7	16	14	0.00	10.83
United Technologies Corporation	UTX	53.97	55	50	0.00	7.36
Wal-Mart Stores, Inc.	WMT	48.86	50	45	0.00	7.90
Alcoa Inc	AA	10.14	10	9	1.38	10.00
American Express Company	AXP	29.38	29	27	1.29	6.90
Bank of America Corporation	BAC	12.19	12	11	1.56	8.33
Boeing Co.	BA	43.02	43	40	0.05	6.98
Caterpillar Inc.	CAT	39.48	39	37	1.22	5.13
Chevron Corp	CVX	66.25	65	60	1.89	7.69
E.I. du Pont de Nemours and Company	DD	28.32	28	26	1.13	7.14
Exxon Mobil Corp	XOM	70.47	70	65	0.67	7.14
General Electric Company	GE	11.47	11	10	4.10	9.09
Hewlett-Packard Co.	HPQ	40.57	40	37.5	1.40	6.25
The Coca-Cola Company	KO	50.35	50	47.5	0.70	5.00
The Home Depot, Inc.	HD	24.46	24	22.5	1.88	6.25
The Procter & Gamble Company	PG	55.49	55	50	0.88	9.09
Travelers Companies Inc	TRV	40.71	40	35	1.74	12.50
Verizon Communications	VZ	30.32	30	28	1.06	6.67
Walt Disney Company	DIS	25.2	25	23	0.79	8.00

These options expire on August 22, 2009; therefore the last trading day is Friday August 21, 2009.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly. To learn more about the option spread strategy and other option strategies check out my option trading books.

If you're more bullish / bearish you’ll want to adjust the strike price accordingly. If you’re even more bearish, sell a put much lower than the one purchased, or don't sell a put at all. The cost will be more expensive to open the contract, however the downside protection will be greater.

This strategy is a great way to hedge your portfolio. One reason option volumes have exploded over the past 5 years is because they are a great way to hedge your portfolio (see chart here).

Below is a picture of the spreadsheet I used to calculate these values (click on the image to enlarge).




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