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Bearish Options Strategies for Income

Bearish Options Strategies for Falling Market Conditions

Bearish options strategies are for those traders who believe the price action of the underlying asset is about to move, or continue, downwards. In order to choose the most effective strategy, traders should have some idea about how far they think the price could fall and how long it might take to do so.

There are some classic chart patterns which may help here.

For example, the head and shoulders pattern or the double top. Once the neckline has been breached, anticipated price targets can be set and the optimum bearish options strategy chosen.

Bearish divergences using certain indicators can also be useful, but not so much for predicting potential price targets.

Here are a list of bearish options strategies, which we will explore in the order given.

Long Put
Synthetic Long Put
Short Call
Synthetic Short Stock
Collar
Bear Call Spread
Bear Put Spread
Put Calendar Spread
Ratio Put Spread

Going Long Put Options

The simple put buying strategy is utilized by most novice options traders. It is simple and easy to understand and brokerage costs are minimal. The question then becomes, which is the most effective strategy?

Do you buy out-of-the-money, at-the-money or in-the-money options?

The answer depends on the level of risk to reward you wish to take.

Out of the money options are the cheapest and if the underlying makes a strong move downward, can realize the best return on risk. But these options are cheaper for a reason. The price reflects the probability that the options will have any intrinsic value at expiration date - and that probability is low.

They also have a low options delta, which means their value is less sensitive to price movements in the underlying than 'at the money' or 'in the money' options are.

Buying at-the-money (ATM) options provides the best outcome if the anticipated price drop occurs within a short time frame.

In-the-money (ITM) and deep ITM options with a delta of at least 85 don't give as much return on risk as ATM options, but they do provide a greater safety net against adverse price movements.

In the money options still provide handsome returns though - usually around 10 times the profit you would've made if you had simply shorted the stock.

Synthetic Long Put

This involves short-selling the stock while purchasing call options for protection. The purchase of a Call option allows the short seller to establish a bearish position with limited risk. Because of the level of margin involved when shorting stocks, it is not a popular strategy.

Profits on shorting the stock are only limited by the difference between the current market price of the underlying and zero, while losses on the call options are limited to the premium paid. Once the stock price drops by the same amount that the call options cost, you've reached break-even. From here on, it's pure profit.

The Short Call

Bearish options strategies of this type offer limited profit potential and the possibility of large losses in the event of large price advances. Because this is an uncovered (naked) position, your broker will usually require considerable capital in your account to cover the potential risk involved.

Synthetic Short Stock

This involves buying put options and simultaneously selling the same number of call options at the same strike price and expiration date. Since both positions effectively create the same rights and obligations, it is equivalent to having shorted the stock.

However, these bearish options strategies are often designed using options with two different strikes. For example, with XYZ at $60, the investor would build the spread using the 65 Call and the 60 Put (Collar).

Because this position is either equivalent to short stock (same strike price) or closely approximates short stock (split strikes), the investor utilizing this strategy must be aware that its risk/reward profile is theoretically unlimited risk and unlimited reward.

However, if the synthetic position is converted to a three legged box spread, on certain types of stocks or ETFs, then a whole new horizon of opportunities arises.

This strategy is most often used when XYZ is near the mid-point between the two split strike prices.

First, the spread is often established for little or no debit.
And secondly, it provides a little room for XYZ to rally before the short Call becomes in-the-money.

The trader should watch the price action of the underlying asset for possible assignment, which could occur if it rallies above the Call's strike price.

The Collar

This is similar to the Synthetic Short Stock, the only difference being, that two strike prices are chosen. You go long the same number of at-the-money puts and short out-of-the-money calls.

Bear Call Spread

A Bear Call Spread is a type of Vertical Credit Spread. It contains two Call options with different strike prices. The highest strike option is the long Call. The short Call's strike price is one of the strike prices below the long Call. Since the short call will be more valuable than the long call, you receive a credit to your account.

For further reading and analysis, go to our page on bear call spreads.

Bear Put Spread

A Bear Put Spread is a vertical Debit Spread. It is the exact reverse of the Bear Call Spread and contains two put options with different strikes.

The higher strike option is the long Put while the short Put is one of the strike prices below the long Put. This strategy has a different risk to reward profile than the credit spread alternative.

Put Calendar Spread

A Calendar Spread (sometimes called a "Time Spread") contains two options with the same strike price but different expiration months. Out of the money puts are the options of preference because of the trader's bearish bias, but you could also use 'in the money' puts.

Ratio Put Spread

Bearish options strategies of this nature involve going short a greater number of put options than the ones you buy. Your short options should be at lower strike prices than your long ones, which should be at-the-money.

This strategy is most effective when the price of the underlying is between the two strike prices. It will also result in some written put positions that are not covered by long puts.

The spread has limited upside risk. If the spread is established for a debit, that is the maximum you can lose if the underlying asset is above the long put strike price at expiration date.

If done for a credit, there is no upside risk. Because assignment of the underlying asset is possible, should this happen, the downside risk can be large if the stock price falls sharply before expiration date.