By Chris Ebert
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Q: I’m nearly certain that the share price of ConAgra Foods (NYSE:CAG) will be much lower 2 – 3 months from now. Is there a way to use options to short CAG in a way that would not expose me to too much risk? They report earnings on 12-19. – Jeff Pierce
A: One way to start is to go with the old, hackneyed advice: If the stock price is falling, buy puts. But, I think we can improve on that advice somewhat, and in the process we will be able to take better control of the exposure to risk.
First, let’s start out with an attempt to buy a put. But, which put? Which expiration date? If a put with the December 21, 2013 expiration is purchased and the earnings report on the Dec. 19 causes a temporary spike in the stock price, the trade would experience a loss even if the prediction of the share price being much lower in 2-3 months was later proven correct. So, for the intended use of the put option being to profit from a longer-term drop in the share price, it is therefore less risky to use a more distant expiration, such as March 22, 2014.
Choosing a strike price can have a huge effect on the outcome of the trade.
- Low strike price, low risk, profits will tend to be very small
If the expectation is that the price may fall 10% from the current $33, then a strike price of $30 may initially appear to be the best choice. The $30 strike puts with March expiration are currently trading for about $0.45 per share, so the cost of a single contract of 100 shares is just $45, which is very affordable. The risk is also very low, since $45 is the maximum loss that could occur on the trade. However, these options would likely produce little or no profit unless the share price fell well below $30. To look at it another way, the prediction of a 10% decline in the stock price could be correct and the trade might experience a loss.
- Moderate strike price, moderate risk, small to moderate profits are possible
Choosing an at-the-money strike price, where the strike price is nearly the same as the current $33 share price, is another alternative. But, at a cost of $1.20 to $1.40 per share, the maximum loss on the trade could be as high as $140 per contract. The risk at the $33 strike is much higher than the $45 maximum loss at the $30 strike, and yet the profit potential is only slightly higher than that of the $30 strike put. In this case, the stock could decline 10% while the put experiences only a very small gain.
- High strike price, high risk, large profits are possible
By far, the best option for capturing the greatest gain when the stock price declines is an in-the-money put, where the strike price is well above the current share price of the stock. The only problem – the premium on such options is much higher than the premium at other strikes, and since the entire premium can be lost if the share price unexpectedly surges higher, the risk of loss is much greater. As an example, the $35 strike puts with March expiration currently have a premium of $2.85, or $285 per contract, all of which may be lost if the option becomes worthless due to an increase in the share price, but these options would experience a gain of nearly 100% if the stock price fell 10%. (more…)