6 Stocks that Make Good Bear Call Spread Writing Candidates

by: Hedgephone

When looking to write bear call spreads on stocks, investors obviously have to find names that they believe will fall or stay rangebound in the future. Selling a bear call spread means that investors write an at the money or slightly out of the money call option against a stock while buying a further out of the money call option, usually in the same contract month on the same stock. Shorting stocks carries the potential for unlimited risk, and anyone who has traded individual stocks from the short side this year (besides reverse merger Chinese fraud stocks) has likely had their fair share of losing trades. Bear call spreads are a good way to limit risk when betting against a company or index fund.

The reason for the trend towards investors covering shorts at steep losses this year is the fact that most hedge funds are likely not managing their short book risks by purchasing a protective call option. I have been guilty of this lack of discipline a few times this year myself, though I have not been caught too badly in the higher beta shorts as I could have been.

Don't get me wrong, like many traders I am bearish on the momentum names right now. But the short covering driving them up has created some vertical chart patterns and there is no point in fighting the tape. Some traders I know have recently noted that the only "action" in this market has been created from scared shorts covering for large losses and delusional momentum investors who believe they are part man and part God. We try to find the overall direction of the markets based on fundamental valuations, macro trends, technical analysis, trend following techniques, and common sense. If we think the market is headed up, we tend to cover most of our short book even if that means taking small losses.

Using a bear call spread approach instead of a "short and hold" approach would have helped investors (and me) avoid much of the pain that arose this year, either from the obnoxious short covering/momentum HFT pumping that has ruled the markets or simply getting the analysis wrong. The market as of late has had a tendency of placing 100 PE ratios on the more speculative issues, while punishing cheap stocks with strong cash flows and earnings.

The current "blow off top" in several of the more ridiculously valued high beta names leads me to believe that the momentum game is almost over. It may be time to re-enter some bear call spreads on a few of our favorite overvalued individual investment ideas, though we have been short the overall market via QQQ and IWM puts since 7/7/2011 (see our market direction call here). We normally use tight stops on short positions, but we are more focused on options trading at this point because put spreads have built in stops losses in place and therefore less risk than a direct short position. Here are 6 option trades on stocks or ETF's that, well, only a dentist, real estate broker/daytrader, stay at home mom, or doctor could love. Here's how to execute bear call spreads to bet against them while defining your risk. (P.S., I am only joking, many stay-at-home moms and dads are much better traders than I am!)

IWM -- The Russell 2000 is still trading for a PE ratio north of 30 and last week's strong rally in equities was likely caused by a large liquidity injection by the Federal Reserve, not strong fundamentals in individual stocks. I don't like being "told" to buy anything, especially an equity investment. So this prodding has not worked on me and I doubt that the Fed will be able to scare people into stocks or out of short positions in the near future. Any net short investor, however, should be fearful of QE3. By using bear call spreads, short sellers limit their risk but also limit their potential profits. Because of the "herky-jerky" actions of the central bankers around the globe, bear call spreads make a lot more sense to me than going all in on the short side right now, and I am sure that is the goal of such a volatile central banking policy. Unfortunately the real issues hurting the market right now are European insolvency and a weak Euro which hurts S&P earnings. The price to book of the IWM is a whopping 3X so investors could make a good deal of money shorting this index fund over the longer term. Selling a bear call spread seems more conservative, however. While I want everything to magically heal and stocks to be worth their current price tags, I have been around the block enough to be a skeptic.

BXP -- Boston Properties is a name which looks expensive on a price to cash flow basis and a price to earnings basis, although PE ratios are less useful for REITS than free cash flow metrics. What concerns me the most about Boston Properties is that real estate has not firmed, yet the REIT sector is making new all time highs. While rents have risen somewhat, the bottom line is that commercial property is likely not going to maintain the momentum that the current rent rally has provided -- at least not as much as investors think it will. Dividends for BXP and other REITs are not large enough to compensate for the risks in my view. Therefore, when looking to enter into a bear call spread, Boston Properties appears to be a solid candidate. Investors can sell the August $115 call options and can buy the October $130 calls for a calendar spread. With calendar spreads, you can be wrong in the short run and still make money thanks to time decay.

YOKU -- While Youku.com is an interesting web company and could one day monetize its web presence, today the stock looks overvalued. That said, the site carries an Alexa.com ranking of 53, which in the short run is likely to matter more to investors than financial statements or earnings. While value is in the eye of the beholder on the web, metrics like price to adjusted free cash flow and price to sales are still important. Investors should not lose sight of the fact that in 2000, the same type of stocks were sold off heavily even though these sites had web clicks, eyeball count, and a huge user base. This time might be different, but the jury is still out for now on valuing web stocks. Internet stocks have traditionally moved in giant trends. While I am not a perma-bear on this name at all and I do respect Tom Marsico who owns this stock for size, I do think a bear call spread using high enough strikes could make traders some money here. Investors can sell the October $45 call options and buy the October $60 call options for a hedge. Time decay will be working on your side on such a trade and if the stock stays range-bound, rises slightly or falls, you will make your maximum profit from this investment.

YNDX -- Yandex is the Russian Google (NASDAQ:GOOG) according to Wall Street, but the stock is clearly not a risk-free proposition at current valuations. Yandex is trading for 55X forward earnings but over 70X trailing earnings, though one can argue that these earnings are not stable given the current political climate in Russia and the cyclical nature of internet stocks in general. Investors can sell the Nov. $34 Yandex call options for $2.75 and buy the same amount of $40 November. Yandex call options for around $1.10 per contract. This "trade" can yield a max profit of $1.65 a share at November expiration. That is a 4.8% return on a full short position in the stock, and it yields a monthly return of approximately 1.2% per month or 14.4% annualized if the stock remains at or below $34 at November expiration. If the stock heads to $41.10 a share, investors will suffer their maximum loss of $4.35 or around 12% on a full short position in the stock. This compares to a loss of over $7.50 per share on a full short position which is open-ended if the stock heads even higher from $41 a share.

ZAGG -- Zagg makes IPhone skins and accessories. While the company is selling product in what appears to be a bull market sector of the economy, competition in this sector is quite high. Zagg is a well run business with strong growth, but the company has little in the way of a moat and is fairly concentrated as far as sales are concerned with a large concentration of revenues from Best Buy (NYSE:BBY). Citron Research has done some nice work on this stock and is currently bearish on the name. Investors who want bear call spread exposure here can sell the August $12.50 calls for $1.20 a contract and buy the August $15 cals for around $.40 a contract. This "trade" has a max loss of around $1.70 cents or so with a max profit of around $.80 cents. Investors who are truly bearish on the stock can simply add to the position if it jumps above $14 or so, or can buy additional calls if the story changes and investors become bullish. Citron pegs their one month price target for ZAGG at $8, so to me this type of risk reward trade looks strong.

QQQ -- The NASDAQ 100 has rallied an incredible 100% plus from the lows back in March 2009, and the index currently sits above the highs of 2007. While the excitement around technology names and web 2.0 is contagious and I am a fan of the new technology sector at the right price, I think some of the optimism is unwarranted. I doubt that the QQQ will trade higher than $60 this summer, so investors can consider selling the September $60 calls and buying the September $65 calls for a nice risk reward bear call spread, either as a hedge against a long position or a more directional style short bet against the tech index. Keep in mind that the Nasdaq is still around 50% below the all time highs set in 2000. So over the long term, the jury is still out on the internet investment craze -- buying stocks at 500X earnings was not a great strategy in 2000 and I doubt times have changed all that much from then until now. That said, "shorting" index funds is a lot safer and less risky than shorting individual stocks. I have found shorting individual names to be difficult over the past six months, and personally feel that index bear call spreads make more sense here than trying to pick tops in overvalued names.

Disclosure: I am short QQQ, IWM, BXP, YNDX, ZAGG.

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