The Hindu Business Line : Mildly bearish? How to profit from it

Placing option bets in highly volatile markets such as the present one may require derivative traders to exercise their grey cells more intensively. After all it is no easy task to make money in a market that appears to have a mind of its own.

So, if you are mildly bearish on the markets, don’t just buy a put or short the market blindly– remember volatility can kill your capital in no time.

Instead, use bear spreads that not only limit your maximum loss potential, but also give you an array of risk-return spreads to choose from.

When to use this strategy?

Consider using a bear put-option spread when you are moderately bearish on the underlying. However, if you are extremely bearish on an underlying, this strategy may not be best suited as it will limit your returns potential.

Options spreads, because they are essentially low-return strategies, are ideally suited for traders who have a lower appetite for risk.

How to set a bear put spread

You can set this spread by buying a put option with a higher strike price (in-the-money) and simultaneously selling a put with a lower strike (out-of-money) on the same underlying asset with the same expiration month.

This strategy, unlike the bear call-spread (discussed previously in this column) is a debit spread, since it will entail an initial outflow of money. This is because price of the purchased option will be higher than that of the option that will be sold and hence setting a bear put will involve an initial net debit.

For instance, if you are mildly bearish on Nifty and feel that it will trend down in the next few days, you can set a bear put spread by buying 4400 Nifty July put option (trading at Rs 112) and simultaneously selling 4300 Nifty July put option (trading at Rs 59). The cost of setting the spread will be the difference in the premium between the two options (in this case, Rs 53).

However, remember to execute both the legs of the strategy simultaneously as that will help you lower the margin money required for writing options.

Risk-return payoff

Essentially a low-risk and low-return strategy, this spread will deliver range-bound returns depending on the price movements of the underlying index or stock.

Maximum profit potential: The maximum profit for this spread will occur when the price of the underlying moves below the strike price of the option that was sold (option with the lower strike price).

Maximum profit potential however will be limited to the difference between the two strikes minus the net debit paid or the cost of setting the spread.

In this case, the maximum profit will be Rs 47 [(4400-4300) – Rs 53]. Breakeven point: The breakeven for the spread lies between the strike prices of the put options that have been transacted.

It can be calculated as follows – upper strike price minus net debit paid. (In this case, 4400-53). Maximum loss potential: When your spread is totally out of money i.e. when the underlying price is higher than the strike price of the purchased option, the maximum loss that you can suffer will be limited to the net debit paid – that is the money that was spent initially in setting the bear put spread. In our example, the maximum loss will be limited to Rs 53.

So, in essence as far this example is concerned you will be taking a maximum risk of Rs 53 to earn a maximum profit of Rs 47.

This risk-return payoff, however, can be changed to suit your appetite by tweaking the strike prices of the options involved. For instance, the same strategy when set using 4400 and 4250 puts will enjoy different risk-return potential. Since the maximum profit that can be earned though this strategy is limited, traders should consider booking profits and closing the positions as soon as the underlying trends below the strike price of the sold put option. On the downside, if you feel that the likelihood of the underlying moving down is low, you can consider a premature closing of positions before hitting the maximum loss scenario.

Bear put vs. bear call

Both bear put and bear call spreads in essence benefit from a downward movement in the price of the underlying. So, in order to decide on which strategy to use when you are mildly bearish, first compare the risk-return payoffs for both the strategies.

Depending on the time value of money and the volatility in prices, the two strategies will involve a different risk-return matrix. Besides that, since a bear call spread involves an initial credit at the time of setting it, the same can be chosen over the bear put if you are temporality tight on cash. That said, it primarily should be the risk-return payoff for the two spreads that should determine your final choice.

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