Bear put option spreads | It provides downside protection and time to react
As cattle futures shoot for the moon, some feeders have strapped on parachutes in case the engines flame out.
They are using bear put option spreads to make sure they can bail out if the rally fails.
“If it does go to 200 (cents per pound), let it go, but we know at some point it’ll be down to 180 when the market breaks,” said Calgary broker Errol Anderson of Pro Market Communications.
Anderson is establishing downside price protection by buying $1.90 August 2014 Chicago Merchantile Exchange feeder cattle put options for his clients, which is slightly less than where futures have been trading. That put option allows a holder to sell CME feeder cattle futures at a price of $1.90.
The premium paid is relatively expensive because they are close to being “in-the-money,” which reduces the insurance value of the option.
However, by having the buyer simultaneously sell a put for $1.84, the premium from that sale can be used to subsidize the purchase of the more expensive put and make it more affordable and better protection.
“It gives the guy six cents (per lb.) downside protection, and we’re getting it for around two cents,” said Anderson.
Instead of paying about four cents per lb. for the single $1.90 put option, the feeder ends up paying about a net two cents by writing the $1.84 for about two cents.
This is known as a put option bear spread. In this case, the person who owns the option will benefit if feeder cattle futures prices fall below $1.90 plus the net cost of the premium.
If prices fall below $1.88, the spread begins paying off until prices hit $1.84, which is where the other put kicks in.
If the $1.90 buyer had not also written the $1.84 put, he would collect any decline beneath $1.90, but the $1.84 put limits the downside protection to the six cents zone between $1.90 and $1.84.
As long as both puts remain in force, there’s no risk to the holder of the spread.
Holding the spread allows the feeder to get both a limited amount of downside protection and time to react if the market reverses.
“I really like that kind of trade because it keeps everybody out of trouble,” said Anderson.