Bearish Options Strategies: Option Strategies for a Bearish Market

 

By stating that one is bearish about the market, one means that they are expecting the market to perform negatively for a stipulated timeframe.

This strategy is used when the trader is moderately bearish on the direction of prices of the underlying but wants to reduce his initial cost of long Put by receiving a premium on the short Put. 

Assumption: The underlying and maturity of the contracts remains the same.

To execute this strategy, an investor purchases Put Options of a higher strike price (In the Money) and sells Put Options of the same underlying for a lower strike price (Out of the Money).

There is a net debit in the investor’s trading account, which is equal to the amount gained by selling the lower priced Put Options minus the amount spent on acquiring the higher priced Put Options.

This strategy will start giving maximum profit when underlying moves below the lower strike price. The maximum loss will happen if the underlying moves above the higher strike price. However, the maximum profit is limited to the difference between the strike prices of both the contracts minus the net debit and other charges (brokerage, commissions, taxes, among others). The maximum loss in this strategy is equivalent to the net premium paid.

Illustration

Leg 1: Purchase 1 lot of 25 July 2024 Nifty Put Options of  of Rs. 24900 at a rate of Rs. 150 per unit.

Leg 2: Sell 1 lot of 25 July 2024 Nifty Put Options of strike price of Rs. 24800 at a rate of Rs. 110 per unit.

Net debit = (150 – 110) *25 = Rs. 1000 i.e., Rs 1000. This is the maximum risk when Nifty closes above 24900.

Maximum profit = 24900 - 24800 - 40 = Rs. 60 per unit if Nifty close below 24,800

Since there are 75 shares in 1 lot, our maximum profit for this trade will be 60*25 = Rs. 1500

Let’s understand this example with different scenarios:

Scenario 1: If Nifty closes at 24,700

Leg 1: Premium paid on the Put Option of higher strike price Rs. 24900 = Rs. 150

Premium received on Put Option of higher strike price Rs. 24900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (24900 - 24700)} = Max (0, 200) = Rs. 200

So, payoff from this Put Option = Premium received – Premium paid = 200 - 150 = Rs. 50

Leg 2: Premium received on the Put Option of lower strike price Rs.24800 = Rs. 110

Premium paid on Put Option of lower strike price Rs. 24800 at expiry = Max {0, (Strike price- Spot price)} = Max {0, (24800 - 24700)} = Max (0, 100) = Rs. 100

So, Payoff from the OTM Put Option = Premium received – Premium paid = 110 - 100 = Rs. 10

Net Payoff = Payoff from Rs. 24900 Put Option + Payoff from Rs. 24800 Put Option = 50 + 10 = Rs. 60

Scenario 2: If Nifty close at 25,000

Leg 1: Premium paid on the Put Option of higher strike price Rs. 24900 = Rs. 150

Premium received on Put Option of higher strike price Rs. 24900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (24900 - 25000)} = Max (0, -100) = 0

So, payoff from this Put Option = Premium received – Premium paid = 0 - 150 = - Rs. 150

Leg 2: Premium received on the Put Option of lower strike price Rs.24800 = Rs. 110

Premium paid on Put Option of lower strike price Rs. 24800 at expiry = Max {0, (Strike price- Spot price)} = Max {0, 24800 - 25000)} = Max (0, -200) = 0

So, Payoff from this Put Option = Premium received – Premium paid = 110 - 0 = Rs. 110

Net Payoff = Payoff from Rs. 24900 Put Option + Payoff from Rs. 24800 Put Option = -150 + 110 = - Rs. 40

 

Short Call

This strategy involves selling Call Options when a trader is bearish about the underlying. However, selling or shorting Options assumes theoretically unlimited risk, since the underlying has unlimited upside, therefore, the margin requirement will be there. However, if one is sure about the direction, Calls can be shorted since the effect of time decay would also be in the favor of the Option seller. Hence, the trader gains as option premiums go down because of movement in their favorable direction as well as the theta decay or time decay.