Option Strategies to Consider in a Bearish Market

Bull markets can present many opportunities for investors. They can potentially profit from holding onto valuable companies long term and using several trading strategies. However, traders can also potentially make a profit in bearish markets and generate positive returns. While some people panic sell during bear markets and avoid assets, some options strategies may let you benefit from downward movements in stock prices. Traders have opportunities available to them in any market condition, and this article will cover options strategies that can help you in a bear market.

What Makes a Market Bearish?

Bearish markets aren’t good for long-term investors because prices fall, but what distinguishes a bear market from a short-term market blip? A market becomes bearish when indexes fall 20% from their peaks. It’s also possible for some individual stocks to become bearish even if the market is not bearish. Markets in bearish territory can stay in that condition for a prolonged period of time. The dramatic stock market recovery from the lows of March 2020 is an exception rather than the rule. 

Why You Can Use Bearish Options Strategies

Bearish options strategies allow traders to potentially make profit from declining asset prices. Traders can ride on downward momentum and potentially grow their portfolio at a time when most investors are losing money. Some long-term investors allocate a small percentage of their assets into bearish options strategies to help hedge their portfolios. 

4 Bearish Options Strategies

Bearish options strategies can potentially increase returns and minimize the impact of an economic downturn on a trader's portfolio. These strategies can help traders navigate a bear market.

1. Buying Puts

Buying puts is a popular options trading strategy because of its ease of entry, especially for beginners. They are less complicated than other options strategies. A put contract gives you the right but not the obligation to buy 100 shares at a strike price you decide when buying the contract. Put contracts become more valuable when the underlying asset loses value. 

Example of Buying Puts

The asset, strike price and expiration date impact the premium. Suppose a stock trades at $105 per share, and a trader pays a $2 premium to buy a put with a $100 strike price that expires in four weeks. This options trader needs the stock to fall below $98 to break even. Every cent below $98 represents a profit not including any potential fees. The option will retain some of its value if the underlying stock’s price stays between $98 and $100 per share, before expiration. If the stock stays flat and never falls below $100, the option will expire worthless.

If the long put has gained in value, many options traders sell to close their open puts before they expire so they may be able to obtain profits and not worry about exercising the contract. .

2. Bear Call Spread

A bear call spread caps your potential gain but minimizes your downside. Traders can create bear call spreads by selling a call with a lower strike price and proceeding to buy a call of the same asset with a higher strike price. Selling a call nets you a premium, and the trader uses a portion of those premiums to buy a call with a higher strike price. Purchasing a call creates a spread and shields your portfolio from considerable losses if the stock dramatically runs up, similar to GameStop Corp.’s parabolic rise at the start of 2021.

Example of Bear Call Spread

Suppose a trader believes a stock valued at $50 per share is bearish and won’t go up within the next two months. This trader can sell a call with a $55 strike price to collect a $3 premium and purchase a call with a $60 strike price for a $1 premium. The net premium is $2 per share, or $200 total, excluding brokerage fees. Because the trader collected a $2 premium and is obligated to sell 100 shares at $55 per share if assigned, the breakeven price is $57 per share. Every cent above $57 per share represents a loss. The trader would want the stock price to remain flat during the two months leading up to the expirations of the call contracts.

What if the stock surprises everyone and rises to $80 per share during those two months? This would represent a substantial loss for someone who sold a call without buying a corresponding call to create the spread. A trader who only sold the uncovered call with a $55 strike price would face a $23 loss per share, or $2,300. However, buying the call with a $60 strike price caps the loss at $300. Every cent above $60 per share gets canceled out since the long call would cap potential gains above its strike price.

3. Bear Put Spread

A bear put spread involves two put contracts with the same underlying asset and expiration date. These traders are bearish but do not believe a stock is set to plummet. These traders buy a put and then sell a put with a lower strike price. Selling a put with a lower strike price acts like a discount on the long put position. If you buy a put with a $50 strike price for a $2 premium and sell a put with a $45 strike price for a 50-cent premium, you only end up paying a $1.50 premium. Saving $50 makes the loss not sting as much if the underlying asset never reaches your strike price. 

Someone engaging in this trade would need the underlying stock’s price to fall below $48.50 to break even ($50 strike price - $1.50 premium = $48.50 breakeven price).

The max gain from this trade is $350 ($48.50 breakeven price - $45 strike on shorted put = $3.50). Every cent below $45 per share gets effectively canceled out between the long put with a $50 strike price and the short put with a $45 strike price. 

4. Out-of-the-Money Naked Calls

Out-of-the-money naked calls involve selling calls far out of the money without owning any shares. If a stock is priced at $50 per share, a trader using this strategy may sell an out-of-the-money call with a strike price of $80. The premium is lower when you go far out of the money, but you also reduce the likelihood of getting assigned. The majority of options traders selling naked calls do not want to get their contracts assigned.

Selling closer to the money increases your premiums for each trade but also increases the likelihood of having to purchase 100 shares at market price and then selling those 100 shares at the agreed-upon strike price. You can buy a call to close the position before expiration if you want to get out of it sooner. This strategy is very risky as the maximum loss is theoretically unlimited, since a stock can rise forever.

Things to Consider

Bearish options trading strategies can help manage downside risks and potentially generate positive returns during economic cycles when most people are losing money. Before using these strategies, investors should consider their financial goals and how options trading can align with them. Bearish options trading strategies used in moderation can act as a useful hedge and potentially generate positive returns. However, an overreliance on these strategies can create more risks. You should assess your risk tolerance before getting involved with any asset. Every investment has an inherent risk and potential reward. Some risk-reward setups are more desirable than others. Investors and traders may benefit from picking risk-reward setups that cater to their personal preferences.

Navigating a Bear Market

Bear markets can intimidate investors and tempt them to sell shares in valuable companies. Experienced investors and traders may view bear markets as potential opportunities that can help them achieve portfolio gains. Knowing what you want to accomplish with your portfolio in the next decade and planning out your future can help you pick options trading strategies that can get you closer to your financial goals. 

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