Bearish Options Trading strategies for Falling Markets
Bearish Option Trading strategy is best used when an options trader expects the underlying assets to fall. It is very important to determine how much the underlying price will move lower and the timeframe in which the rally will occur in order to select the best option strategy. The simplest way to make profit from falling prices using options is to buy put. However, buying put is not necessarily the best way to make money in moderately or mildly bearish markets. Following are the most popular strategies that can be used in different scenarios.
Extremely Bearish - Long Put
Moderately Bearish - Bear Put Spread
Long Put Options Trading
When should you initiate a Long Put Options Trade?
A Long Put strategy is best used when you expect the underlying asset to fall significantly in a relatively short period of time. It would still benefit if you expect the underlying asset to fall gradually. However, one should be aware of the time decay factor, because the time value of put will reduce over a period of time as you reach near expiry.
Why should you use Long Put?
This is a good strategy to use because the downside risk is limited only up to the premium/cost of the put you pay, no matter how much the underlying asset rises. It also gives you the flexibility to select the risk to reward ratio by choosing the strike price of the options contract you buy. In addition, Long Put can also be used as a hedging strategy if you want to protect an asset owned by you from a possible reduction in price.
|Strategy||Buy/Long Put Option|
|Market Outlook||Extremely Bearish|
|Breakeven at expiry||Strike price - Premium paid|
|Risk||Limited to premium paid|
Let’s try to understand with an example:
|Current Nifty Price||Rs 8200|
|Strike price||Rs 8200|
|Premium Paid (per share)||Rs 60|
|BEP (Strike Price - Premium paid)||Rs 8140|
|Lot size (in units)||75|
Suppose Nifty is trading at Rs 8200. A put option contract with a strike price of Rs 8200 is trading at Rs 60. If you expect that the price of Nifty will fall significantly in the coming weeks, and you paid Rs 4,500 (75*60) to purchase a single put option covering 75 shares.
As per expectation, if Nifty falls to Rs 8100 on options expiration date, then you can sell immediately in the open market for Rs 100 per share. As each option contract covers 75 shares, the total amount you will receive is Rs 7,500 (100*75). Since, you had paid Rs 4,500 (60*75) to purchase the put option, your net profit for the entire trade is therefore Rs 3,000. For the ease of understanding, we did not take into account commission
How to manage risk?
A Long Put is a limited risk and unlimited reward strategy. So carrying overnight position is advisable but one can keep stop loss to restrict losses due to opposite movement in the underlying assets and also time value of money can play spoil sports if underlying assets doesn’t move at all.
A Long Put is a good strategy to use when you expect the security to fall significantly and quickly. It also limits the downside risk to the premium paid, whereas the potential return is unlimited if Nifty moves lower significantly. It is perfectly suitable for traders who don’t have a huge capital to invest but could potentially make much bigger returns than investing the same amount directly in the underlying security.
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