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Using options to play a bearish equity market

05 Jan 2023

What exactly is a bearish market? It is an expectation that prices are going to fall. Well you can define bearishness in terms of the overall market index or in terms of specific stocks and sectors. For example, in 2008 traders across the world were virtually bearish on all asset classes. Similarly, most traders and investors in India continue to be bearish on IT and Pharma due to the global headwinds over the last few quarters. Thanks to options you can now actually take a bearish view on the markets. Being bearish does not just mean selling your holdings and staying out of the market. With a robust options market, you can hold on to your existing equity positions and yet play the markets on the downside markets. Here is how it can be done
1.  What do you do if you expect the Nifty to go down?
You can just buy a plain vanilla put option on the Nifty. Say, the Nifty is currently quoting at around the 9800 mark and you expect the Nifty to correct towards the 9200 mark. You can play this trend by buying the 9700 put option by paying a premium of, say Rs.70. That means your profit in the event of a fall in the Nifty will start from 9630 onwards. On the downside, your profits will be unlimited. This has two major implications. Firstly, you do not have to worry about exiting your equities and incurring capital gains liability but instead you can play the downside using put options. Secondly, the profit on the put options will ensure that you are sitting on liquidity when the markets get closer to the 9200 levels, enabling you to buy stocks at bargain prices.
2.  You are bearish but also are worried of the RBI cutting rates
This is a slightly modified version of the first scenario. You do expect the markets to go down and have therefore sold futures on the Nifty. But you are worried that if the RBI cuts rates in its monetary policy meet then the markets could shoot up and that will mean huge losses on your short Nifty futures position. You can create a protective call. If you have sold Nifty futures at Rs.9750, you can hedge your position by buying a Nifty call option of 9800 strike. Although this has a cost, you are protected in case the RBI decides to cut rates in its policy meet. Of course, your view on the market continues to be bearish and you are just trying to protect yourself in a worst case scenario.
3.  You are bearish on the market but not too much
You are bearish on the Nifty but you also believe that the valuations of Nifty stocks are just too compelling. Therefore any sharp correction, according to your view is largely ruled out. Let us say, the Nifty will not correct from 9800 to 9200 but only till 9600. How do you play this moderately bearish view on the market? You can create a bear put spread on the Nifty. So you buy a Nifty put option of 9800 strike and sell the Nifty put of 9600 strike. The premium you receive on selling the 9600 put partially compensates for the premium you pay on the 9800 put. Your maximum loss is not the premium paid on the 9800 put but your net premium paid (premium paid on 9800 minus premium received on the 9600 put). A bear put strategy works perfectly when you are moderately bearish on the markets and yet want to play it using options. Remember, options unlike futures are not binary. That means it just not result in loss or profit. You can create parabolic alternatives using options and the bear put spread is a case in point.
4.  OK, you are not entirely bearish, but believe upsides are capped
This is a normal dilemma that trades have. They are not sure if the markets will go down marginally or substantially but they are almost confident that the Nifty is unlikely to go above the 9900 mark. What to do under these circumstances? The answer is to sell a 9900 call option on the Nifty. Assuming that you receive a premium of Rs.75 on that position, you are protected till a Nifty level of 9975. The idea is that the Nifty will expire below the level of 9900 and you will earn the entire Rs.75 as profit on the trade. Here you are not buying a put option because you are not confident on covering the cost of your put and also making profits on top of that. Under these circumstances, selling a call option works perfectly. However, it needs to be remembered that this has the possibility of unlimited losses. If Nifty goes above 9975 then the losses of the option seller can be unlimited.
Options being a non-binary product, you can customise options strategies based on whether you are strongly bullish, moderately bullish or bullish with uncertainty. With the power of options you can create option combinations of your choice that are suited to specific needs.

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