How to Trade Options in Bear Market

Bear markets reflect slowing economic growth and corporate financial problems. Fearful traders panic and dump their holdings at a loss, which pushes stock prices down further and ignites a fresh round of selling. Investors can use several bear-option strategies to profit from a market-wide selling frenzy.

Buying put options is a straightforward bear strategy with low risk/high reward potential. The goal is for the stock price to drop below the put option strike price so the option is in the money prior to expiration. The amount of risk is limited to the option price plus the commission. For example, a stock is trading at $45 a share. You buy an out-of-the-money put with a strike price of $40 for $3 multiplied by the 100 stock shares one option controls, for a total cost of $300. You profit when the stock trades below $40 a share before the option expires.

Trading bear put spreads limits your loss while providing a good return. The trade works by buying an in-the-money put and simultaneously selling an out-of-the-money put. The maximum profit is reached when the stock closes below the out-of-the-money put prior to expiration. The maximum loss is the amount you pay to enter the trade plus commission.

Looking at another example, a stock is trading at $28 a share. You buy an in-the-money put with a strike price of $30 for $20 and simultaneously sell an out-of-the-money put with a strike price of $25 for $17, for a net debit of $300 ($20-$17=$3 x 100=$300). If the stock price remains below the $25 strike price of the short put at expiration, your profit is the difference between the strike prices minus the cost to enter the trade: Strike prices of $30 - $25 = $5 x 100 = $500 minus the net debit of $300 = $200 profit less commission.

Collect money upfront by trading a low-risk bear call spread. The profit is the premium paid by buying out-of-the-money calls while simultaneously selling in-the-money calls. The out-of-the-money calls act as insurance in case the market moves against you and limits your loss to the difference between the strike prices less commission.

For example, a stock is trading at $27 a share. You buy one $30 out-of-the-money call for $100 and sell one $25 in-the-money call for $200 for a net credit of $100 less commission. As long as the stock price remains below the $30 higher strike price, you have a profit.