Shares of Canadian oil and gas exploration and production company Penn West Petroleum (NYSE:PWE) have been on a steady march downward since Spring, losing almost 40% of their value in the last 3 months: (Source: Google Finance)
Like many energy stocks this one has been throttled alongside the global economy, and if the latest round of gloomy economic data is any indicator, it may not be done dropping.
Stocks that drop this much can always keep going until $0 of course, but there is still a little cushion built in on a drop like this. If we are bearish on PWE, but think it only has about another 20% to drop, this could be a perfect situation for a bear put spread.
Bear Put Spread
The situation we described above is perfect for a bear put spread because what we will do in a trade like this is actually take a small long position by selling a put, and we will use those proceeds to help offset the cost of a larger short position we get by buying a put.
What we will do here is simulate this bear put spread trade so we can see what would have happened if we did indeed take the plunge. To be clear we are not advocating this trade, we are instead interested in seeing what we can learn as this hypothetical trade plays out. Bear put spread good!
The Sound of a Bear Working on a Chain
Let's have a look at the options chain for PWE: (Source: ETrade)
Penn West last traded at $12.75 so the $13 put is just about ATM (at the money). The asking price on that option is $1.80 for the Dec 22 expiration. The $11 put represents about almost a 20% drop from where PWE trades currently, and there is a bid on that $11 put for $.80. What we will do with our bear call spread is buy the $13 put and write (sell) the $11 put. This effectively lets us profit from any move downward until PWE hits $11, and our total outlay is $100 ($180 - $80).
Let's compare this to shorting a stock outright. If we short 100 shares of PWE and it goes to $11, we have made $175 ($1,275 - $1,100). If we set our bear call spread and PWE goes to $11 we have $200 after expiration (the put we sold is worthless, the one we bought has intrinsic value of $1,300 - $1,100). We made $100 off of our original $100. Sweet!
Now what about if PWE gets bought out for $50 a share? Well, if we shorted out-right we would have lost a whopping $3,725 ($5,000 - $1,275), yikes! How about our bear put spread? Only the original outlay of $100 can be lost. Bear put spread good!
We will monitor this trade over the course of its life to see what we can learn as things with Penn unfold. Bear put spreads are a great strategy for cutting down the amount of risk we take on when we take a bearish position. These spreads are especially useful if we think a stock will sink but not crash. Remember by that same token the spread cuts off the maximum we can profit on a sinking stock.