Bear markets reflect slowing economic growth and corporate financial problems. Fearful traders panic and dump their holdings at a loss, which pushes stock prices down further and ignites a fresh round of selling. Investors can use several bear-option strategies to profit from a market-wide selling frenzy.
Buying put options is a straightforward
bear strategy with low risk/high reward potential. The goal is for the stock
price to drop below the put option strike price so the option is in the money
prior to expiration. The amount of risk is limited to the option price plus the
commission. For example, a stock is trading at 45rs a share. You buy an
out-of-the-money put with a strike price of 40rs for 3rs multiplied by the 100
stock shares one option controls, for a total cost of 300rs. You profit when
the stock trades below 40rs a share before the option expires.
Trading bear put spreads limits your loss
while providing a good return. The trade works by buying an in-the-money put
and simultaneously selling an out-of-the-money put. The maximum profit is
reached when the stock closes below the out-of-the-money put prior to
expiration. The maximum loss is the amount you pay to enter the trade plus
commission.
Looking at another example, a stock is
trading at 28rs a share. You buy an in-the-money put with a strike price of 30rs
for 20rs and simultaneously sell an out-of-the-money put with a strike price of
25rs for 17rs, for a net debit of 300rs (20rs-17rs=3rs x 100=300rs). If the
stock price remains below the 25rs strike price of the short put at expiration,
your profit is the difference between the strike prices minus the cost to enter
the trade: Strike prices of 30rs – 25rs = 5rs x 100 = 500rs minus the net debit
of 300rs = 200rs profit less commission.
Collect money upfront by trading a
low-risk bear call spread. The profit is the premium paid by buying
out-of-the-money calls while simultaneously selling in-the-money calls. The
out-of-the-money calls act as insurance in case the market moves against you
and limits your loss to the difference between the strike prices less
commission.
For example, a stock is trading at 27rs a
share. You buy one 30rs out-of-the-money call for 100rs and sell one 25rs
in-the-money call for 200rs for a net credit of 100rs less commission. As long
as the stock price remains below the 30rs higher strike price, you have a
profit.
TIP
One option controls 100 stock shares, so
multiply the put or call option price times 100 to get the total buy or sell
cost.
WARNING
Bear markets have brief rallying periods before continuing their downward march. Monitor your option trades and have an exit strategy in place.
