Before we begin with the bearish strategies, it is important to have an understanding of F&O trading. Trading in Futures and Options (F&O) falls under the derivatives market where traders speculate on the price movements of properties such as stock, commodities, or indices without actually taking their ownership. It is meant to give leverage to traders for their positions and hedge risks toward profit-making opportunities.
Futures contracts, in essence, bind the trader to either purchase or sell an asset at a determined price on a given future date, whereas an Options contract provides the right to buy (call option) or sell (put option) an asset at a price predetermined by a contract during a contractually specified time.
What Are Call Options And Put Options?
A call option allows the holder to buy an underlying asset at a predetermined price before expiration, thus it is favored by bullish traders expecting the price to increase.
A put option allows for the exercise of the right to sell an asset at a predetermined price before expiration and is favored by traders expecting prices to eventually decline.
Now that we understand the mechanism of F&O trading, we can move on to explore some of the profitable bearish strategies that traders can use to generate profits.
1. Short Selling in Futures
Short selling is one of the simplest bearish strategies in F&O trading. Here, traders sell a futures contract expecting the price to decline. If the price drops, they buy it back at a lower rate, making a profit on the difference.
Example:
Should the Price ABC chart decline from INR 1,000 to INR 900?
Sell Futures at INR 1,000.
Once at INR 900, Buyback, making a profit of INR 100 per share.
Very risky as the stock goes higher can lead to unlimited losses.
2. Buying Put Options.
Of all the instruments available for bearish traders, put options are the most effective in driving profits from falling asset prices and are inherently limited in risk to the premium that is paid.
For instance:
- If Nifty is trading at 18,000 and the trader expects it to decline, will buy a put option having a strike price of 17,800 for a premium of INR 50.
- If Nifty falls to 17,500, the value of the put option will increase, resulting in a profitable trade.
- This strategy is effective as the losses are capped at the premium paid while the potential profits can be enormous.
3. Bear Put Spread
The bear put spread results from buying a put option with a high strike price and selling a put option with a low strike price. Bear put spreads limit both expected profit and loss, providing a risk-managed approach.
Example:
- Buy the Nifty put option at 18,000 for INR 100.
- Sell Nifty put option at 17,800 for INR 50.
- Net cost (max loss) = INR 50.
- Max gain INR 200 (difference between strike prices minus net costs).
- Bear put spreads work best for those traders who carry a moderately bearish view since they balance risk and reward.
4. Bear Call Spread
Techniques in the bear call spread require traders to sell a call with a lower strike price while buying a call option and put option with a higher strike price. This strategy generates limited profit in case the underlying asset stays below the strike price of the sold call option.
Example:
- Sell Stock XYZ call option at INR 1,000 at INR 50.
- Buy Stock XYZ call option at INR 1,050 at INR 20.
- The net premium received = INR 30.
- If the stock price stays below INR 1,000, this allows the trader to earn a profit of INR 30.
- Controlled risk and limited downside movement suit these traders best.
5. Straddle and Strangle (Volatility Bearish Trade)
- For those traders anticipating volatility but having an equally bearish bias, the straddle and strangle strategies come into play.
- Short Straddle
- A short straddle consists of selling a call and a put at the same strike price that profited from low volatility.
- Assuming it is trading at INR 500, a trader sells both a 500 call and a 500 put.
- The trader earns from the premium collected if the Stock stays around INR 500.
Short Strangle
- The short strangle is designed to sell out-of-the-money options (one put and one call) and thereby profit from the decline of volatility.
- Assume it is trading at INR 500, sell a 480 put and 520 call.
- Should the stock hover near this range, profits from premium decay accrue to the trader.
- These strategies could, however, be dangerous if the stock moves too strongly in either direction.
6. Protective Put (A Hedging Strategy)
For traders that are taking long positions, but suspect a downturn, a protective put strategy can hedge some of that risk.
Example:
A trader buys shares of stock ABC at INR 1,000. To hedge the put option, they purchase the stock at INR 950. This puts the trader in the black when the price falls below INR 950 and compensates for his loss as insurance. This strategy is a great way to protect investments against uncertainty.
Conclusion
Opportunities abound in F&O trading to profit from bearish outlooks. Traders can choose whether to short directly, use put options, or employ spread strategies depending on risk appetite and market outlooks. A good understanding of F&O trading along with what call options and put options are will help the trader implement effective bearish strategies.
While the above strategies are profitable ones, the trader also has to mitigate the risks by way of using stop losses and some hedging strategies. If conditions change, this premeditated strategy will help the trader maximize the profits and minimize the losses.
