What Is a Covered Bear?

A covered bear is a trading strategy in which a short sale is made against a long position, but without closing out the existing long position. This is sometimes known as "shorting against the box". This results in a neutral position where all gains in a stock are equal to the losses and net to zero. The purpose is to avoid realizing capital gains from a sale to close, and so it has been restricted by regulators in practice.

A covered bear strategy can still be implemented without the use of direct short selling, instead using derivatives contracts such as buying a protective put or put spread.

Key Takeaways

  • A covered bear involves going short against an existing long position, without closing out the long.
  • Used by longs who wish to temporarily hedge or protect against a near-term downside move, the strategy involving short selling, or "shorting against the box" is no longer legal due to its tax-avoidance implications.
  • Instead, a covered bear strategy can still be achieved by using offsetting positions in futures or options markets, or by selling short similar but not identical securities.

Understanding Covered Bears

A covered bear is a covered strategy where the investor shorts a stock that they already own. When an investor uses this strategy, he feels that the stock is a bear stock and will decline in value. The risk involved in this strategy is limited because the investor already owns the underlying stock and can use those shares to cover.

This is in contrast to when an investor sells stock that they do not own, which is known as an uncovered bear, or also can be called a naked trade. If the investor goes with the uncovered strategy, they may be forced to borrow the stock in order to produce it for the buyer. Or they can avoid the obligation of delivery by trading in the futures market.

However, selling short shares you own and not closing out the existing long position, or selling short against the box is also a tax avoidance technique used by traders when they do not actually want to close out their long position on a stock. By selling short in a different account and maintaining the long position, no capital gains are realized and any new gains produced by one account will be equally offset by losses in the other. The Taxpayer Relief Act of 1997 (TRA97) no longer allowed short selling against the box as a valid tax deferral practice. Under TRA97, capital gains or losses incurred from short selling against the box are not deferred. The tax implication is that any related capital gains taxes will be owed in the current year.

A bear spread strategy is one option that might be appealing to an investor who wants to minimize their risk while still staying active in the options market.

Covered Bear Considerations

Investors can write and purchase options as a type of covered bear strategy. Covered option trades afford investors more protection than a naked trade where the investor does not own the underlying security that he is hedging against. If the price of the underlying security doesn't fall, then the investor can let the option expire.

Employing a bear spread of any type gives an investor a better chance of realizing a profit while reducing the risk of loss if the stock prices continue on a downward momentum.

Despite their potential advantages and their appeal to investors who enjoy strategic hedging, covered bear strategies, and bear spread strategies in general, are not for everyone. They have some intricate elements that can be challenging to master, especially for the new or casual investor.

Bear spreads are generally considered a more advanced, sophisticated investing strategy. For that reason, they would usually only be advised for more sophisticated, knowledgeable investors, or those who are being directed with guidance from an experienced investment advisor.

Example of a Covered Bear

An example of a covered bear could be a bear spread, which is an options strategy that gains in value as the underlying asset drops, involving the simultaneous purchase and sale of either puts or calls for the same underlying contract with the same expiration date but at different strike prices.

Say an investor owns 1,000 shares of XYZ stock, which is currently trading at $50, but is concerned about a pullback prior to an earnings announcement in three months' time. The investor can buy 10x $45 put and sells (writes) 10 of the $40 put, each expiring in three months, for a net debit of $0.25 per spread. The best case scenario is if the stock price rises and the investor only loses the $250 in total options premium. The worst case scenario is if the stock price ends up at or below $40, where the spread maximizes its payoff of $5,000, partially offsetting the $10,000 lost in the long stock position.