Making a case for a bearish outlook is one thing, but a strategy that profits from that view is quite another. Shorting stock is an obvious choice, but the unlimited risk of that strategy can be unappealing — not to mention the paperwork involved in setting up those types of accounts.
The options market lends itself to bearish strategies, most of which can be initiated with limited risk. Buying puts is the most obvious example, as the maximum your client can lose is the cost of the put. But buying puts is not always the optimal strategy because so many factors in the option-pricing equation work against the buyer.
Sometimes, it makes more sense to take advantage of the metrics associated with the option price. In that category, strategies such as “bear call credit spreads” come to mind.
Consider the bearish case for Thomson Reuters Corp. (symbol: TRI; recently priced at US$27 a share). TRI is known in the financial services business for its dedicated Eikon data terminals, which supply real-time market data and research to analysts, traders and brokers worldwide. More broadly, the firm is known for its Reuters news wire feed, as well as its legal, tax and accounting publications.
With all that intellectual property at TRI’s command, you’d think the firm could have parlayed its early digital advantages — it was one of the first in electronic distribution of information — into a larger market share over later competitors, such as Bloomberg LP. But, at last count, there were some 300,000 Bloomberg terminals vs 15,000 Eikon terminals.
Unfortunately, TRI is still struggling to digest the US$17-billion acquisition of Reuters Group PLC in 2008. And in TRI’s latest quarter, it reported a loss of US$2.57 billion, or US$3.11 a share, following a one-time, US$3-billion writedown on its goodwill.
Bullish clients might argue that the latest quarter was affected by a non-recurring event. But when you consider that this writedown follows a long string of flaccid earnings stretching back five years, you can understand why the market is losing patience and stockholders are losing value.
TRI’s solution is to sell divisions and pare costs. That’s all well and good, but a bear would ask: “Where’s the growth?” Without growth, you end up with a scenario similar to Research in Motion Ltd.’s, which feels suspiciously like a death by a thousand pinpricks.
If you buy into the bears’ position, you have to believe that more bad news — and lower share prices — are coming. The natural tendency is to buy puts — which, by the way, has worked out well for those bearish on RIM.
But, unlike RIM, TRI pays a healthy dividend (and has for some time) that yields 4.8%, which, assuming the market believes it is sustainable, should support the shares. With a sharp sell-off less likely, it is hard to see how a long TRI put strategy makes money.
That’s where the bear call spread comes into play. At the time of writing, you could sell the TRI August 27 calls at US$1.50 while buying the August 32 calls at US15¢. This spread nets a credit of US$1.35 a share, the maximum return for this strategy.
In order for this position to gain the benefit of the advantageous margin requirements associated with spreads, the long call must expire at the same time or later than the short call.
The advantage with the bear call spread is that TRI’s share price does not have to decline for the position to be profitable. If TRI simply stays at current levels (i.e., US$27) through the August expiration, both options would expire worthless and your client would retain the net credit.
The worst-case scenario sees TRI rally above US$32 a share, at which point any losses associated with the short August 27 call would be offset by gains in the long August 32 calls. The maximum risk is the difference in strike prices (US$32 minus US$27 = $5 a share) less the net credit received (US$1.35), which equals US$3.65. IE