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Vertical spread options can assist an investor hedge a position in a bearish market while still maintaining the long position. To illustrate this, let's look at Caterpillar Inc (NYSE:CAT), the Dow Jones Industrial component.

Caterpillar is a best-of-breed construction and mining machinery company combining sound management with a recent string of strong earnings. The company beat analysts' 1Q EPS target handily while raising 2012 guidance to a midpoint of $9.50 a share.

Caterpillar stock price and volume -- One Year


(Click to enlarge)

Source: bigcharts.marketwatch.com

Nonetheless, the stock has been hammered of late. Worries over China's economy slowing down, the EU debt crisis, and generally pessimistic investor sentiment have caused shares to fall from $103.84 to $88.68 since reporting earnings on April 25. This is a 14 percent drop in less than a month. But are we near a short-term bottom? Indeed, Caterpillar has a beta of 1.9, so this large cap equity is nearly twice as volatile as the overall market. In the event of a full-on market correction, this stock could fall a lot further.

If an investor continues to have a long-term positive view of a company, what option strategies may help hedge the downside, while still maintaining the long position?

Let's look at some specific CAT vertical spread options to do the trick.

Vertical Spread Options

Vertical spread options are two-legged options strategies with different strike prices, but the same expiration date. In our case, we will combine two bearish spreads: the Bear Put Spread and the Bear Call Spread.

The Bear Put Spread will be longer-term. It is a net debit option strategy. The Bear Call Spread is a short-term income strategy. It will provide a net credit, thereby reducing the overall cost of the hedge.

The Trade

  • Caterpillar stock price: $88.68
  • Bear Put Vertical Spread: Buy August 87.5 strike put for $6.40 and Sell August 75 put for $2.45. NET DEBIT is $3.95
  • Bear Call Vertical Spread: Sell June 97.5 strike call for $0.77 and Buy June 100 strike for $0.45. NET CREDIT is $0.32

Analysis and Rationale

The total cost for this hedge is $3.63 ($3.95 minus $0.32).

If Caterpillar stock rises above $97.50 by the June expiration, the Bear Put Spread will end up worthless, and the Bear Call Spread will start to go negative. If the stock rises quickly, the worst case scenario for the hedge results in a stock price above $100 a share by June. The maximum loss is sustained: $3.63 per share. However, the long position will have appreciated $11.32 per share ($100 minus $88.68). The net underlying stock gain is $7.69; plus the investor still holds the long position. An unhedged 13 percent gain would be cut to about 9 percent.

Going out farther on the calendar, if Caterpillar stock is range bound between $87.50 and $97.50 through August expiration, the cost of the hedge is lost. The maximum loss is $4.81. If the stock remains at it's current level, the cost premium for hedging the position is 4 percent. However, note that the investor may continue to sell call options (either via another net credit spread or straight covered calls) for the August expiration, further mitigating the net debit for trade.

Now let's review the anticipated scenario: a bearish view of Caterpillar stock during the summer months.

Remember, the hedge was to prevent heavy capital loss for just this event!

If CAT stock falls below $87.50 a share, the investor will mitigate the decline in share price with the purchased $87.5 strike puts. Let's say the stock bottoms out at $75, the puts will be worth about $12.50 each at expiration. Subtracting the cost of the hedge (minus $3.63) and the share price loss until the put kicks in ($1.18) offers a net credit of $7.69. When coupled with the actual share decline from the current price to $75, a potential 15 percent tumble is reduced to 6.7 percent.

I selected the $97.50 lower strike based upon the Caterpillar 200-day moving average. Often times, the 50 or 200-day moving averages act as technical resistance for a stock. Lower strikes offer the investor a bigger credit, thereby lowering the cost of the overall hedge.

The lower strike August 75 put was sold based upon two premises. First, the current 2012 lowest analyst EPS estimate is $9.31 a share. I cut it further to $8.50. The lowest reasonable P / E multiple I placed upon ttm earnings is 9X. Therefore, I envision a potential low of $76.50 a share. This assumes a significant cut in earnings with extreme investor pessimism. Certainly, those assumptions are up for debate.

Please note that if the stock were to fall below $75 a share, the investor would experience a dollar for dollar decline in the long position. The hedge assumes CAT shares stay above $75 each. It should also be recognized that the investor will be entitled to any dividends, as he/she continues to hold a long position.

Conclusion

Vertical spreads can be used in a variety of ways to produce income or hedge a long position whereas the investor has either a bullish or bearish sentiment. In this case, we applied Bear Call and Bear Put Spreads to Caterpillar stock with a bearish summertime view.

In this specific example, a net hedging cost of about 4 percent provides the investor the ability to mitigate a potential 15.4 percent downside risk to 6.8 percent from now until August expiration. In consideration for this protection, the investor cuts their potential gain from 12.8 percent to 8.7 percent through June. The net cost for the hedge may be further improved if the stock does not rise through June and another round of call spreads or covered calls are written for August.

Whenever placing option trades, consider all scenarios and understand the risk/reward in detail. The strike prices used here were illustrative. The risk/reward can be altered significantly by widening or tightening them. Some option traders also "leg in" to their positions and further improve the spread costs. Finally, brokerage commissions are integral to your situation. I did not include fees or commissions in my example.

Disclosure: I am long CAT.

Source: Hedging Caterpillar Stock With Vertical Spread Options