Narach Investment

OPTIONS TRADING STRATEGIES IN A BEAR MARKET


When the stock market and the stocks traded in them are in a bearish mode both the Call options and Put options are available to an investor. Keeping this in view and that the stock market were to be in a bear phase, the investor would be able to utilize the Put option in a bearish Put spread strategy or the Call options in a bearish Call spread strategy.

Put options in a bearish strategy: When the investor purchases a Put option, he would be long and expect the market to fall; as this Put position is a bearish position, and would increase in value if the market were to fall. So, an investor who has a bearish outlook of the market would purchase Put options of select underlying assets. By buying Put options, the investor would have the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obliged to buy the underlying at a higher price.

An investor's profit potential is practically unlimited; as the higher the fall in the price of the underlying asset, higher would be the profit. The investor's potential loss would be limited. If the price of the underlying were to rise instead of falling as the investor may have anticipated earlier, he would let the Put option expire worthless; and his loss would be the premium he had paid earlier to purchase the Put option. The investor's breakeven point would be the exercise price minus the premium. So, to make a profit the market price of the underlying asset must be below the exercise price; since, the investor has paid a premium, he would also be required to recover this premium amount he would have paid.

An increase in volatility of the price of the underlying asset would increase the value of the Put option and increase the return. As an increase in the volatility would make it more likely that the price of the underlying asset would move down.

Call option in a bearish strategy: Another option for an investor with a pessimistic outlook of the market would be to go short on a Call option, with the intent of purchasing it back in the future. By selling a Call option, he would have a net short position which needs to be bought back before expiration and cancel out his position.

To implement this, the investor would need to write a Call option. If the market price of the underlying asset falls, the long Call holders would let their out-of-the-money options expire worthless; as they could purchase the underlying asset directly from the market at the lower market price.

The investor's profit potential would be limited, as the maximum profit would be limited to the premium received earlier for writing the Call option. Here the loss potential would be unlimited, as a short Call position holder has an obligation to sell if exercised; he would be potentially exposed to large losses if the price of the underlying asset were to rise against his position. The investor would breakeven when the market price of the underlying asset equals the exercise price plus the premium. At any market price greater than the exercise price plus the premium, the investor would be losing money.

An increase in volatility would increase the value of the Call and thus decrease the return to the investor. When the option writer has to buy back the option in order to cancel out his position, he would be forced to pay a higher price due to the increased value of the Call options.

Put options in a bearish strategy: A vertical Put spread is the simultaneous purchase and sale of identical Put options but at different exercise prices.

To "buy a Put spread" would be to purchase a Put with a higher exercise price and write a Put option with a lower exercise price. The investor would pay a net premium to establish this position. To "sell a Put spread" would be the opposite; where the investor buys a Put option with a lower exercise price and writes a Put option with a higher exercise price, while receiving a net premium for the position.

To put on a bear Put spread the investor would buy the higher strike price Put and sell the lower strike price Put. This would be true for both the Put option and Call option to set up a bear spread. An investor with a bearish market outlook would buy a "Bear Put spread", which allows him to participate to a limited extent in a bear market, while at the same time limiting his risk exposure.

The investor's profit potential is limited; as when the market price of the underlying asset falls to or below the lower exercise price, both Put options would be in-th-money, and the investor would realize the maximum profit when he recovers the net premium paid for the Options. The investor's potential loss would be limited, as the investor has offsetting positions at different exercise prices. If the market price of the underlying asset were to risk rather than fall, then the Options would be out-of-the-money and expire worthless. Since the investor has paid a net premium.

The investor would breakeven when the market price of the underlying asset equals the higher exercise price less the net premium; when the market price falls below this point the investor profits. For the strategy to be profitable, the market price of the underlying asset must fall.

To illustrate the above, let's assume that the cash price of an underlying asset is ₹100.00; and investor buys a Nov Put option at a strike price of ₹110.00 at a premium of ₹15.00; and simultaneously sells a Put option with a strike price of ₹90.00 at premium of ₹5.00.

In this bearish position, the Put is taken as long on a higher strike price Put with the outgo of some premium. This position has huge profit potential on the downside. The investor may recover part of the premium paid by writing a lower strike price Put option. This would result in a mildly bearish position with a limited risk and limited profit profile; as while reducing the cost of taking a bearish position, the investor has also capped the profit potential. The maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum Profit = Strike price of higher Put option − Strike price of lower Put option − Net Premium = ₹110.00 − ₹90.00 − ₹10 = ₹10.00

Maximum Loss = Net premium = ₹15.00 − ₹5.00 = ₹10.00

Breakeven point = Strike price of higher Put option − Net premium = ₹110.00 − ₹10.00 = ₹100.00

Call options in a bearish strategy: A vertical Call spread would be the simultaneous purchase and sale of identical Call options but with different exercise prices.

To "buy a Call spread" would be the purchase of a Call with a lower exercise price and simultaneously write a Call with a higher exercise price. The investor would pay a net premium for this position. To "sell a Call spread" would be the opposite; where the investor would buy a Call with a higher exercise price and simultaneously write a Call with a lower exercise price. The investor would receive a net premium in this case.

To put on a bear Call spread the investor would sell the lower strike Call and buy the higher strike price Call. An investor with a bearish market outlook would sell a Call spread. The "Bear Call Spread" would allow the investor to participate to a limited extent in a bear market, while at the same time limiting his risk exposure.

The investor's profit profile is limited; as when the market price of the underlying asset falls to the lower exercise price, both out-of-the-money Call options would expire worthless. The maximum profit the investor would realize would be the net premium received earlier. The investor's potential loss is limited. If the market price of the underlying asset were to rise, the two Call options would offset one another. At any price greater than the higher exercise price, the maximum loss would equal the higher exercise price minus the lower exercise price minus the net premium. And the investor would breakeven when the market price of the underlying asset equals the lower exercise price plus the net premium.

To illustrate the above, let's assume that the cash price of an underlying asset is ₹100.00. The investor now buys a Nov Call option with a strike price of ₹110.00 at a premium of ₹5.00 and sells a Call option with a strike price of ₹90.00 at a premium of ₹15.00.

In this spread, the investor would be required to purchase a higher strike price Call option and sell a lower strike price Call option. As the lower strike price option would be more expensive when compared with the higher strike price option, this would be a net credit strategy. The final construct of the position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum Profit = Net premium received = ₹15.00 − ₹5.00 = ₹10.00

Maximum Loss = Strike price of higher Call option − Strike price of lower Call option − Net premium = ₹110.00 − ₹90.00 − ₹10.00 = ₹10.00

Breakeven Point = Strike price of lower Call option + Net premium = ₹90.00 + ₹10.00 = ₹100.00

We would strongly recommend that the investor first study these investment instruments along with the above listed strategies; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him. The strategies provided here are academic in nature; and the information should be used by investors who are aware of the risks inherent in investing and trading in options in the equity markets amongst other financial instruments. Narach Investment accepts no liability whatsoever for any loss arising from the use of this website and its contents.