You’ve landed yourself in one of the most lucrative stocks, and it just seems to keep going up uphill. Instead, with every good climb, the higher chances there are for a sharp downturn. As any trader or investor, you don’t want to cash in too early and not avail yourself of the upside potential, yet at the same time, you’re anxious about an abrupt decline. The problem is how to lock in your current profit and still be able to enjoy the ride if the stock soars even further.
This is an especially common dilemma for stocks like Tesla that have had parabolic moves, only to see extreme pullbacks. You are not alone in this thought, since many traders and investors have faced the very same situation. The good news is that smart strategies to hedge against losses yet still leave room for further upside have been developed by experienced traders.
Now, we will investigate one such options strategy, the modified bear put spread, that will allow you to protect your profit in a stock while still reaping further gains in that stock. This spread is designed with the trader in mind who would like to take some profits, but not entirely remove the position. It truly is the best of both worlds here, as you get downside protection and upside potential.
Parabolic Stocks Risk of Sharp Declines
After huge runs higher, stocks are often at risk of falling significantly. This is through the roof for stocks like Tesla, as has been shown time and over during the last couple of years. For example, Tesla had an amazing rally in the first half of 2024 and rallied 90% off its lows. The traders are still timid with regard to a sharp pullback, in that such stocks normally pull back after monster rallies.
The question is, how do you protect your stock profit without selling the shares of your stock? You definitely wouldn’t want to lock in those profits only to then see that stock continue on up. And neither do you want to hold tight and watch your profit go up in smoke if it pulls back. That’s where the smart options strategy comes into play.
What Is Modified Bear Put Spread?
One of the most efficient methods of hedging those stock profits involves something called the modified bear put spread. This will allow you to protect against a potential decline while your shares stay in your possession. You can even create positive cash flow by adding a short call position as you implement the hedge.
In the bear put spread, one would be buying a put option with a higher strike price and selling one with a lower strike price. This version activates upon the addition of a short call to help finance the trade. This now sets up a structure that protects your downside but still allows participation if the stock continues higher.
How Does The Strategy Work?
Let’s try to break down the modified bear put spread with a real-world example of Tesla stock from late 2023 to early 2024. An investor who had Tesla shares at a cost basis of $110 wanted protection from profits as the stock surged to $256. Around December 20th, he executed the following trade:
- Buy 5 Tesla put options with a $250 strike price, which is just below the current market price.
- Sell 5 Tesla options with a strike price of $195, where the stock had earlier found its support.
- Sell 5 Tesla calls with a strike price of $265, the level at which the stock had already met resistance.
What he is doing, in effect, is putting together these three trades to construct an adapted bear put spread. The short call at $265 brings in enough money to cover the cost of the puts, the trader enjoys positive cash flow, and downside protection remains in place.
Why the Modified Bear Put Spread Is Effective
This strategy is powerful for a number of key reasons:
Downside Protection:
If the stock price falls, the long put option at $250 increases in value, thereby countering the loss of the stock’s value. In our Tesla example, that stock had fallen back to $184.26 by early February 2024, and the trader’s put options had increased handily in value to cover the losses accruing from the stock.
Upside Potential:
This ATM short call at $265 caps the potential profits, but only above that level. For this limitation on upside gains, the trader receives downside protection and positive cash flow in return. If Tesla continued to rise, for instance, the trader would have still made up to $265 per share.
Financing the Trade:
The $265 short call helps finance the put spread—meaning the trader isn’t tying up as much cash to establish the hedge. In fact, in this Tesla example, the trader collected positive cash flow of $1,360 at the initiation of the trade.
Flexibility:
It is a strategy that offers protection of the profits from stock without necessarily selling your shares. Most investors are quite hesitant to sell due to capital gain taxes or strong feelings that the stock would continue rising over the long term. The modified bear put spread commissions one risk management strategy while remaining invested.
Results of the Hedge
By early February 2024, Tesla had fallen to $184.26—a far cry from its highs set earlier. Even with that precipitous decline, though, the trader who had shorted the modified bear put spread was able to close out his hedge for more than a $27,000 profit. That nearly offset the loss from the drop in the Tesla shares—a huge psychological payoff for the trader.
Meanwhile, for the corresponding trader who did nothing to hedge it, that drawdown would have been much larger, turning over more than $35,000 in profits. Tesla rebounded to $260 by July 15, 2024, but the trader who hedged that position still came out very far ahead of an un-hedged trader, over $100,000 in total profits.
Important Considerations When Using This Strategy
While the modified bear put spread is powerful, it is very important to grasp the following limitations and risks:
Short Call Risk:
The risk in selling the call option is simply having the obligation to deliver shares if that stock is trading above the strike price. In this case, Tesla closed above $2 so he would have had the obligation to sell his shares at that price. Since the trader was already long the shares, it’s not as risky like being “naked” on the calls.
Possible Assignment:
The short puts in this strategy would be assigned if the stock price of Tesla fell below $1,950 before expiration. In other words, the trader would have been obligated to buy more Tesla shares at $1,950. This would, however, be a plus for some traders, as it would be at an even better price, especially as long as they think Tesla is undervalued at this level.
Profit Limitation:
While this is an excellent downside protection strategy, yes, above-profit strike price of the short call does cap it. Above $265 rallies, the trader is not participating in any upside beyond that level.
Conclusion
Hence, a modified bear put spread solves the problem when one has protection for stock profits but still wants upside. Adding short calls to the bear put spread lets it finance the hedge and protect downside, but captures upside gain to a certain point. This is a smart options strategy that gives traders means to protect gains during tumultuous markets. If hedging your stock positions is your aim, then this strategy should be considered and applied with the principles we discussed to protect your portfolio without maybe losing future gains. Remember, the key in trading is not to make profits but protect what you have made when the market turns against your positions.