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Best Option Strategies When you are Bearish About the Market

24 Feb 2022 0 COMMENT

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

While buying naked Options can be one way to go, experienced and strategic investors often use a combination of techniques to hedge their positions, in case their predictions turn out to be wrong.

Some of these strategies keeping a bearish market in mind with examples are listed below:

1) Buying naked Put Options:

Simplest of all strategies, buying a Put Option for an underlying when there is a perceived bearishness is the most common trading strategy in a bearish market. The maximum profit from this trade theoretically would be when the underlying stock value reaches zero. The maximum loss would be the premium paid to purchase these Options.

Illustration: Purchase 1 lot of 29 July 2021 Nifty Put Options of strike price of Rs. 15900 at a rate of Rs. 61.6 per unit.

Net debit = 61.6*75 = Rs. 4620, since there are 75 quantities in 1 lot of Nifty Options

Maximum profit = Value of the Put Options when the stock goes to zero.

Maximum loss = Total premium paid, i.e. Rs. 4620

Your trade would be profitable if Nifty falls below 15900 – 61.6 = Rs. 15838.4 on expiry. If Nifty closes at 15,800 on expiry, your profit would be (15838.4 – 15800) *75 = Rs. 2880

2) Bear Put Spread:

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: Purchase 1 lot of 29 July 2021 Nifty Put Options of strike price of Rs. 15900 at a rate of Rs. 150 per unit.

Sell 1 lot of 29 July 2021 Nifty Put Options of strike price of Rs. 15800 at a rate of Rs. 110 per unit.

Net debit = (150 – 110) *75 = Rs. 3000 i.e., Rs 3000. This is the maximum risk when Nifty closes above 15900.

Maximum profit = 15900 - 15800 - 40 = Rs. 60 per unit if Nifty close below 15,800

Since there are 75 shares in 1 lot, our maximum profit for this trade will be 60*75 = Rs. 4500

Scenario 1: If Nifty closes at 15,700

Leg 1: Premium paid on the Put Option of higher strike price Rs. 15900 = Rs. 150

Premium received on Put Option of higher strike price Rs. 15900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (15900 - 15700)} = 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.15800 = Rs. 110

Premium paid on Put Option of lower strike price Rs. 15800 at expiry = Max {0, (Strike price- Spot price)} = Max {0, (15800 - 15700)} = 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. 15900 Put Option + Payoff from Rs. 15800 Put Option = 50 + 10 = Rs. 60

Scenario 2: If Nifty close at 16,000

Leg 1: Premium paid on the Put Option of higher strike price Rs. 15900 = Rs. 150

Premium received on Put Option of higher strike price Rs. 15900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (15900 - 16000)} = 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.15800 = Rs. 110

Premium paid on Put Option of lower strike price Rs. 15800 at expiry = Max {0, (Strike price- Spot price)} = Max {0, (15800 - 16000)} = Max (0, -200) = 0

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

Net Payoff = Payoff from Rs. 15900 Put Option + Payoff from Rs. 15800 Put Option = -150 + 110 = - Rs. 40

3) 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 the Option premiums go down because of movement in their favorable direction as well as the theta decay or time decay.

That was all from us on the best Options strategies you can employ when you are bearish about the market! Until next time, happy investing!

Key takeaways:

  • Buying naked Put Options in a bearish market is a good strategy if you expect a huge downside movement in the underlying.
  • 2)& Strategies like bear Put can be effective if you want to cap your losses and you are moderately bearish about the market.
  • 3)Strategies such as short Calls can demand high margin and hence may be avoided by traders with limited capital. However, the dual benefits of time decay and gain due to fall in underlying can be obtained by traders with high risk appetite and high capital.

Disclaimer:

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