How to trade bearish view with options ?

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One of my trader friend asked me following question -

Lets say I am bearish for the next 2-3 months. What strategy can I use?
The Nifty PE of July 2010 are trading at,
5000PE @156.8
4900PE @124
4800PE@101

Now, If I am expecting levels of 4800 minimum in July, how do I use this information to position myself in the market.

There are many options Strategies that can be used to trader our bearish view. (Refer to this post for further details.)

Let me explain the use of Bearish Put Spread to trade the bearish view with an example. With the data provided, it is possible to create 3 spreads with this. Following table list their comparison.

Compare Bearish Spreads

Though last 2 spreads look attractive due to higher reward to risk ratio, but they need market to fall below 4800. With our view of drop till 4800 level, we have less chance of gaining maximum profit on them. First spread, though carries low reward to risk ratio, it carries higher probability of giving us maximum profit. Moreover it has highest breakeven point of all, i.e. it will come into profit below 4967 level. Hence it is a trade-off decision based on our view about
- Are we strongly bearish or mild bearish ?
- Do we want higher probability of small profit or Low probability of bigger profit ?

Of-course, we should also plan to cut our losses (Refer to this post for further details).

Hope this post helps you in planning your next trade.
Feel free to drop me any new question through “conact me” link.

Happy Trading

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5 Comments on “How to trade bearish view with options ?”

  • Raunak Agarwal
    10 June, 2010, 13:18

    Anup, thanks for this. Isn’t this strategy limiting my profit potential ? IMO spreads are good to get a favorable risk to reward ratio, but limit profit potential. If we Buy a naked put, we do risk more, but don’t we get more if we get it right. Is there something which I can do to fit my trading philosophy which is inclined towards making good money when one is right. 

  • Trader anup
    10 June, 2010, 13:57

    Raunak,
    With naked put, u might have unlimited profit potential, but Breakeven point is far. And if market does not move immediately, then due to timedecay the losses will accumulate daily. So just by having 1 legged options position, you are carrying lot more risks for unlimited profit (word unlimited is is questionable).

    And if you apply position sizing logic and limit trade size by risk per trade amount, then spreads will allow you to carry bigger position then long position. Hence, even if max profit is limited, actual profit with bigger position size will be more or less same.

    Let me compare naked long option v/s spread strategies and make a post on that.

    Happy Trading

  • Raunak Agarwal
    13 June, 2010, 19:23

    Thanks Anup.

  • Patel
    1 March, 2012, 10:01

    Anup, what’s your view about trading strangles (http://www.thegammatrader.com/index.php/option-strategies/long-strangle/) on the Indian market? I’m quite bearish on the overall market but I believe that volatility will expand quite a bit when the markets go down, so even though the strangle is market neutral, it should gain if the market tanks. Does my thinking make sense to you?

    I’m considering putting on a strangle and keep rolling it forward until the market makes a larger move down. 

  • Trader anup
    6 May, 2012, 7:24

    Patel, In my view, there is appropriate time for each of the strategy. Long Strangles are great when market has been in low range, low volatility i.e. has been sleeping for some time. As it breaks out from the low range, the strangle will give good return. Being a market neutral strategy, one leg of Strangle will always be the looser, hence it is important to cut the loosing end after breakout is confirmed and let the winner run.
    Do keep in mind that high volatility might not last for long time (cause we human being are not tuned to live in stress for long time hence we take action to adjust asap).

    As you rightly mentioned, when market tanks, strangle will make money. But please do check the historical chart. You will notice then whenever market has dropped vertically, it has bounced back almost 50% or so very quickly before resuming the drop again. That means timing for booking the profit, cutting the loosing legs are more important points.

    Worst part with strangle is the larger time decay hence you have to backtest your system for strangle trading and see if it really profitable or not. If you use this strategy at appropriate market condition then it is profitable strategy.

    Happy Trading

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