Bearish Strategies Using Options

March 21, 2010

Many traders prefer to be short and like bearish strategies.  Bearish strategies can be constructed using puts or calls.  The simplest bearish strategies involve buying put options, or shorting futures.   Buying put options or shorting futures can be rewarding, however buying a put burdens the trader with the problem of time decay.  Of course, time decay is most problematic as options near expiration.  Shorting futures can be effective, however the trader needs to time the market very well.  If the trader is a day early, shorts futures and the market rallies before it falls, significant unrealized loss can force the trader that sells futures out of their position.

Bearish strategies can be deployed using option spreads.  Depending on a trader’s outlook on future implied volatility of the underlying market, various strategies can be effective for individuals looking for bearish strategies.

The most common bearish strategies involve buying a put spread.  The bearish put spread is always put on as a debit, assuming the spread is traded as a spread, rather thane “legging into” the spread.   A put spread is created by owning an option and selling an option.  The option that is owned (the long put  option) is at a strike price higher than the strike price of the option that is short or sold (the short put option).

The profit potential is determined by the profit from the difference in strike prices, less the cost of the put spread, less any commission or transaction costs. The maximum lost is the cost of entering the bear put spread, plus transaction costs.

Bearish strategies can also be created using calls.   A bear call spread is created by selling a call option and buying a call option that is further out of the money.  The trader collects a premium because the call option sold has more value than the call option that is purchased.  The maximum profit is the amount can be collected when the bearish strategy, the bear call spread, if both options expire worthless.  The maximum loss using a bear call spread is the difference between the strike prices less the premium collected, less any transaction costs.

Neither of these spreads are affected very much by time decay, as in each case, you are long and short options with the same expiration.

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