Trading Strategy – Bearish Strategies

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Bearish Strategies

Can we summarise the discussions held last time?

Last time we discussed option strategies which can be adopted if you are bullish. In particular, we elaborately discussed bull spreads. This time let us understand strategies you can follow if you are bearish.

What are the various bearish strategies possible?

The following major choices are available:

  • Sell Scrip Futures
  • Sell Index Futures
  • Buy Put Option
  • Sell Call Option
  • Bear Spreads
  • Combinations of Options and Futures

Let us discuss each one of them now.

What happens if I sell Scrip or Index Futures?

In the current Indian system, when you sell Scrip Futures, you are not required to deliver the underlying scrip. You will be required to deposit a certain margin with the exchange on sale of Scrip Futures. If the Scrip actually falls (as per your belief), you can buy back the Futures and make a profit. For example, Satyam Futures are quoting at Rs 250 and you sell them today as you are bearish. You could buy them back after 10 days at say Rs 230 (if they fall as per your expectations), generating a profit of Rs 20. Question of delivering Satyam does not arise in the present set up.

You will be required to place a margin with the exchange which could be around 25% (an illustrative percentage). If you accordingly place a margin of Rs 62.50, a return of Rs 20 in 10 days time works out to a wonderful 30% plus return.

Obviously, if Satyam Futures move up (instead of down) you face an unlimited risk of losses. You should therefore operate with a stop loss strategy and buy back Futures if they move in reverse gear.

You could adopt the same strategy with Index Futures if you are bearish on the market as a whole. Similar returns and risks are attached to this strategy.

How does a Put Option help in a bearish framework?

The Put Option will rise in value as the scrip (or index) drops. If you buy a Put Option and the scrip falls (as you believe), you can sell it at a later date. The advantage of a Put Option (as against Futures) is that your losses are limited to the Premium you pay on purchase of the Put Option.

For example, a Satyam 260 Put may quote at Rs 21 when Satyam is quoting at Rs 264. If Satyam falls to Rs 244 in 8 days, the Put will move up to say Rs 31. You can make a profit of Rs 10 in the process.

No margins are applicable on you when you buy the Put. You need to pay the Premium in cash at the time of purchase.

When should I sell a Call?

If you are moderately bearish (or neutral or bearish), you can consider selling a Call. You will receive a Premium when you sell a Call. If the underlying Scrip (or Index) falls as you expect, the Call value will also fall at which point you should buy it back.

For example, if Satyam is quoting at Rs 264 and the Satyam 260 Call is quoting at Rs 18, you might well find that in 8 days when Satyam falls to Rs 244, the Call might be quoting at Rs 7. When you buy it back at Rs 7, you will make a profit of Rs 11.

However, if Satyam moves up instead of down, the Call will move up in value. You might be required to buy it back at a loss. You are exposed to an unlimited loss, but your profits are limited to the Premium you collect on sale of the Call. You will receive the Premium on the date of sale of the Option. You will however be required to keep a margin with the exchange. This margin can change on a day to day basis depending on various factors, predominantly the price of the scrip itself.

You should be very careful while selling a Call as you are exposed to unlimited losses.

How do I use Bear Spreads?

In a bear spread, you buy a Call with a high strike price and sell a Call with a lower strike price. For example, you could buy a Satyam 300 Call at say Rs 5 and sell a Satyam 260 Call at Rs 26. You will receive a Premium of Rs 26 and pay a Premium of Rs 5, thus earning a Net Premium of Rs 21.

If Satyam falls to Rs 260 or lower, you will keep the entire Premium of Rs 21. On the other hand if Satyam rises to Rs 300 (or above) you will have to pay Rs 40. After set off of the Income of Rs 21, your maximum loss will be Rs 19.

Satyam Closing Price Profit on 260 Strike Call (Gross) Profit on 300 Strike Call (Gross) Premium Received on Day One Net Profit
250 0 0 21 21
255 0 0 21 21
260 0 0 21 21
270 -10 0 21 11
281 -21 0 21 0
290 -30 0 21 -9
300 -40 0 21 -19
310 -50 10 21 -19

The pay off profile appears as under:

Bearish Strategies

In in a bear spread, your profits and losses are both limited. Thus, you are safe from an unexpected rise in Satyam as compared to a clean Option sale.

How do I use combinations of Futures and Options?

If you sell Futures in a bearish framework, you run the risk of unlimited losses in case the scrip (or index) rises. You can protect this unlimited loss position by buying a Call. This combination will result effectively in a payoff similar to that of buying a Put.

You can decide the strike price of the Call depending on your comfort level. For example, Satyam is quoting at Rs 264 currently and you are bearish. You sell Satyam Futures at say Rs 265. If Satyam moves up, you will make losses. However, you do not want unlimited loss. You could buy a Satyam 300 Call by paying a small Premium of Rs 5. This will arrest your maximum loss to Rs 35.

If Satyam moves up beyond the Rs 300 level, you will receive compensation from the Call which will offset your loss on Futures. For example, if Satyam moves to Rs 312, you will make a loss of Rs 37 on Futures (312 – 265) but make a profit of Rs 12 on the Call (312 – 300). For this comfort, you shell out a small Premium of Rs 5 which is a cost.

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