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How to use options in bearish market conditions

Just as you can use options to make the best of bullish market conditions, you can also use options to make the best of bearish market conditions. The beauty of options is that it can help you work markets both ways. Since options are non-linear you can combine options with options and also options with futures to create elegant hybrid strategies to capitalize on bearish opportunities in the market. So if you expect the market to fall, then you do not have to worry about the falling prices. Rather, you can capitalize on the fall by using the power of options. In fact, you have separate choices whether you are moderately bearish or bearish with conviction.

Options can not only be used in isolation they can also be used in combinations with futures and options. Such combinations are called hybrids. Let us try and understand about the use of bearish option strategies; meaning options trading in bear markets. Trading options in bear markets call for a unique set of strategies to be applied to make the best of the situation. Let us look at 4 such bear option trading strategies.

Trading bearish markets with a naked put option.
This is the simplest use of options in a bearish market. A put option is a right to sell a stock or an index without the obligation to well. That means you will pay the premium to get the right without the obligation. That premium is your option price and represents the maximum loss that you will incur in the transaction. Let us understand that better with a live example.

Investor ViewInvestor ActionInvestor pay-offHas a bearish view on Cummins Industries and expects the stock to go down from Rs.960 to Rs.900 during the monthInvestor buys Cummins 940 put option in February 2018 contract by paying a premium of Rs.22CMP (980) - Loses Premium
CMP (950) – Loses Premium
CMP (920) – Net Loss of Rs.2
CMP (900) – Net Profit of Rs.18   

In the above scenario it is clear that the break-even point for the naked long put option is Rs.918 (strike price of Rs.940 - premium of Rs.22). It is only below the price level of Rs.918 that the trader starts to make net profit. Above Rs.940, the trader is indifferent as he loses his entire premium irrespective of the price. Below Rs.940 he starts to recover his premium cost and keeps recovering it till the breakeven point of Rs.918. It is only below this breakeven point that he starts making profits.

Trading bearish market with insurance via protective call strategy.
A protective call is also a bearish strategy but it comes with a built in insurance. The problem with buying naked put options is that you end up paying a huge premium and more often than not it is difficult to recover the premium amount. That is the reason that in 95% of the cases the option sellers make money while option buyers lose money. An alternate strategy could be protective call where you sell futures and protect it by purchasing a higher call option. In the Cummins example, if you can sell Cummins Futures at Rs.960 and protect yourself with a 970 call option at Rs.12, then your maximum risk is still Rs.22 as in the case of the naked option. But then your breakeven point is Rs.948 as at that point you will cover the cost of the put option too. Remember, when you sell futures there is higher margin payable and also you are subject to payment of mark to market margins. But this strategy essentially brings down your breakeven point.

Moderately bearish strategy via covered put strategy.
What do you do if you are moderately bearish on a stock? In the Cummins case you do not expect Cummins to go down to Rs.900 but only up to 930. In this case you sell Cummins Futures at Rs.960 and then sell the Cummins 930 put option at Rs.10. This effectively improves your average cost of shorting Cummins by Rs.10 and your new effective purchase price is Rs.970. On the downside you earn maximum profit on this strategy at Rs.930. Below that level whatever you gain on the futures is lost on the short put option. But it needs to be remembered that this strategy has open risk on the upside above Rs.970. That is a risk you need to be conscious of.

Moderately bearish strategy via Bear put spread strategy.
The downside of the covered put strategy is that the upside risk is open. That problem can be resolved using a bear put strategy. This is also a moderately bearish strategy. What you do in this case is you buy a higher strike put and sell a lower strike put. So your maximum loss is limited to your net premium. In the case of Cummins, you can buy a 960 put option at Rs.25 and sell a 930 put option at Rs.10. Your maximum loss will be the net cost of Rs.15. Your maximum profit will be Rs.15 at the price level of Rs.930. This is an improvement on the covered put strategy in the sense that the upside risk is also covered.

Whether you are bearish on the stock with conviction or you are bearish to a moderate extent, options offer you a solution to play each of these themes with appropriate combinations.

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