Last week we discussed how to profit from Apple shares rising with less risk. This week we will discuss how to profit from Apple shares falling with less risk.
The Bearish Apple Investor:
The traditional way to profit from a stock falling is to ‘Short’ the stock. Shorting a stock is the process of selling a share before you even own it. Then you hope that the stock price falls where you buy it to ‘close’ your position for a profit. For example …. You could short Apple at $120 (sell it) then weeks later imagine Apple fell to $110. Then you would buy Apple at $110 to ‘close’ the short position for a $10 profit.
If the share price rises then you start to lose on the position.
But there are risks to shorting a stock …. The share price could rise and as we know with Apple and other Technology stocks recently they rose to ridiculous valuations. So your losses can mount for every cent the stock rises. Also, shorting a stock is similar to borrowing the shares from your broker to sell first. There is a monthly interest payment on the facility. So this is an additional cost too.
Is there a less risky way using options?
The answer is Yes!
There are numerous strategies but I am going to focus on the Bear Put Spread strategy …… Before I continue I would encourage you to complete the bear put spread course… it is free to access. If you are new to options you may want to do the basics of call and put options course first.
Let’s get into it…..
The Oct 16th Apple $105/$100 Bear Put Spread.
I’m going to explain this in simple terms. Here are the highlights:
- Risk: $193 for every 100 shares.…. We cannot lose any more than that!
- Reward: $307 If Apple falls to $100 or below we stand to make a profit of $307!
- ROI: 159% if Apple falls below $100.
- Trade Expiry: This trade would be valid until Oct 16th only (26 days from now).
- Probability: 43%. We have a 43% probability of being profitable on this trade.
Let me break down this trade for you. There are two parts to this trade:
- Buy the $105 Put Option for $481 per contract: We are paying $481 for buying the Oct 16th $105 Put option. This part of the trade gives us the right but not the obligation to SELL100 shares of Apple at any time between now and Oct 16th for $105. If Apple falls to $95 for example, we could still Sell it at $105 because we own this Put option. We could just leave this part of the trade on its own if we liked … but the trade does cost $481 to place and if Apple doesn’t fall below $105 by Oct 16th we could lose all of our $481! In fact, Apple would need to fall to $100.19 at expiry in order for us to breakeven. So to reduce the risk in this trade we implement part two ….
- Sell the $100 Put Option for $288 per contract: We are receiving $288 for selling the Oct 16th $100 Put option. This part of the trade gives us the obligation to BUY 100 shares of Apple at any time between now and Oct 16th for $100. If Apple goes down to $95 for example, we would have to buy the Apple shares at $100 because of this Put option. We are ‘covered’ on this part because we own the $105 Put which allows us to Sell 100 shares at $105! By selling the $100 Put we reduced our risk in this trade by $288!
Now our total risk is just $193 ($481 minus the $288).
So we have spent $193 to allow us to sell 100 shares of Apple at $105 and then we limited our profit from a fall to $100. If Apple falls below $120 we can only make the max profit of $307 (for every 100 shares). Remember this is a 159% return on investment!
Is it simpler to just ‘short’ the stock? Yes!
But it is more risky…. There are pros and cons to both strategies…. Let’s have a look! We are going to look at two potential outcomes for shorting 100 shares of Apple at today’s stock price of $106.84:
- Possible Outcome 1: Apple goes to $125
- Possible Outcome 2: Apple drops to $100.
Shorting Apple Stock in the Traditional Way:
- Risk: Unlimited. Technically Apple shares can keep rising!
- Outcome 1: Stock reaches $125. Loss equals $18.16 ($125 minus $106.84) per share or $1,816 for every 100 shares.
- Outcome 2: Stock drops to $100. Profit equals $6.84 per share or $684 for every 100 shares.
- Probability of Profit: 50%. On any given day there is a 50% chance of the share price going up or down.
- Dividends: No …we get penalised for being short as we pay the dividend!
Buying $105/$100 Oct 16th Bear Put Spread
- Risk: Risk is $193 for every 100 shares. This is one of the biggest upsides to participating in Apple using the bear put spread. The capital outlay is just $193 for every 100 shares!
- Outcome 1: Stock reaches $125. Loss equals $1.93 per share or $193 for every 100 shares. Whilst you have lost in this outcome … it is better than losing $1,816 like we did if we ‘shorted’ the stock.
- Outcome 2: Stock drops to $100. Profit equals $307 for every 100 shares. This is not as much as ‘shorting’ the stock but the return on investment is substantial at 159%.
- Probability of Profit: 43%. The probability of profit on bear put spreads will usually be lower than that of shorting the stock itself. This is a drawback on the strategy.
- Dividends: No! You do not get paid a dividend with this strategy.
In summary, as you can see …there are pros and cons to each strategy but it is clear from this example that the bear put spread is less risky than shorting the stock. The bear pit spread can be a real alternative for investors to participate in stocks falling without risking too much capital.
I would encourage you to complete our basics of call and put options and bear put spread courses. They are free to access and you will gain a deeper understanding of the strategy there.
If you would like to consider one to one mentoring please request a call back.
Next week… we will highlight how we can place a High probability trade for investors who want to own Apple but at much cheaper prices!