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The Opportunity
Morningstar’s analyst Michael Holt believes that Red Hat (NYSE:RHT – News), a software company which packages and supports the free Linux operating system, has risen too far too fast, especially considering that it does not own the intellectual property of its cornerstone product. The shares have been on a tear, rising by 100% during the last year. Holt believes that now is the time to sell, and our first of two bearish option strategies allow investors to get paid for making a bet that Red Hat is overvalued while limiting exposure in a way that is impossible for stock investors.

Option Strategy 1–Sell Bearish Call Spread
Selling calls means agreeing to sell stock at a specific price, and selling naked calls (namely, selling calls without covering one’s position with call options purchased at a higher strike) opens one up to theoretically limitless losses. For this reason, we recommend a sell bearish call spread instead. See our Option Recipe Book article on call spreads to review the potential strengths and weaknesses behind this strategy.

Because selling a call spread means contracting to sell a stock at a given price, we like to think of this strategy in terms of effective sell prices. The wider the spread we choose, the higher the effective sell price we can achieve, but the amount of money we have to pony up for margin also increases (as will the amount of our capital at risk). A 30-35 call spread on Red Hat’s shares expiring in January of 2011 generates $1.65 of premium income while risking $3.35 ($5 minus $1.65). Holt believes the batting average for this bet is about 50%, and that given the relatively short tenor, the success or failure of this investment will largely hinge on general market conditions. Here are the details:

To see the related chart, click here:

http://news.morningstar.com/articlenet/article.aspx?id=327399

Option Strategy 2–Buy Bearish Put
With the sell bearish call, we are receiving premium income up front but exposing ourselves to a potential for future financial loss. Another option strategy allows us to turn this dynamic on its head, pay premium expense up front, and allow ourselves the potential for future financial gain. Based on Holt’s fair value estimate for the stock, we can buy a downside wedge of Red Hat’s probability distribution in the form of a 20-strike put expiring in January 2012 for around $2.25. Here again, we limit our possible loss to the $2.25 in premium paid and have the potential to win $6 ($20 minus $14) if the stock price falls to Holt’s fair value price by expiration. (If this concept of “buying a wedge of the probability distribution” sounds foreign to you, please download and read a copy of the Morningstar Guide to Option Investing).

Here are the details on the long put:

To see the related chart, click here:

http://news.morningstar.com/articlenet/article.aspx?id=327399

Alternatives
As mentioned above, because of the short tenor of our sell bearish strategy, Holt believes that the bet is basically a 50-50 coin flip. If the market crashes, our bearish position should allow us to hedge some of our inevitable unrealized losses on our bullish positions; if the market continues to climb, it is likely that Red Hat will climb along with it. In order to improve our batting average on this investment, one could sell the 30-35 call spread expiring in January 2012. This would allow more time for a fundamentally based correction to its mispricing. Options are available through January 2012, but are not heavily traded at that tenor, so pick prices within the bid-ask spread in order to get a better price.

Investment Execution
In our sell bearish strategy, we are a net seller of option premium, so we will need to maintain cash on the sidelines in the account to secure the position. Single-name options in the U.S. are transacted in even lots of 100 (this ratio is termed the contract multiplier), so the numbers above should be multiplied by 100 for each contact you sell. As was mentioned in our Option Recipe Book article on call spreads, we will have to keep the difference between the two strikes less our received premium times 100 (the contract multiplier) in our margin account to secure the position. Remember to make it clear to your broker that this is a spread transaction, so you will be able to receive the benefit of lower commissions. Our maximum loss on the trade will be the total amount in the margin account. In our buy bearish strategy, we need not keep any moneys in reserve–once we pay the premium, we own the option.

U.S. single-name options are American-style expiry, meaning that our put buyer can choose to exercise anytime before or on the expiration date (the third Friday in either January 2011 or January 2012, respectively).

Company Background
For more information regarding Red Hat, please see Holt’s Analyst Report.

To learn more about Morningstar OptionInvestor, click here:

http://option.morningstar.com/OptionReg/purchase.aspx