Bearish Market Trading Strategies
When your outlook on an underlying security is bearish, meaning you expect it to fall in price, you will want to be using suitable trading strategies. A lot of beginner options traders believe that the best way to generate profits from an underlying security falling in price is simply to buy puts, but this isn't necessarily the case.
Buying puts isn't a great idea if you are only expecting a small price reduction in a financial instrument, and you have no protection if the price of that financial instrument doesn't move or goes up instead. There are strategies that you can use to overcome such problems, and many of them also offer other advantages.
On this page we discuss the benefits of using bearish options trading strategies, and some of the disadvantages too. We also provide a list of the ones that are most commonly used.
- Why Use Bearish Options Trading Strategies?
- Disadvantages of Bearish Options Trading Strategies
- List of Bearish Options Trading Strategies
Why Use Bearish Options Trading Strategies?
First, we should point out that purchasing puts is indeed a bearish options trading strategy itself, and there are times when the right thing to do is to simply buy puts based on an underlying security that you expect to fall in price. However, this approach is limited in a number of ways.
A single holding of puts could possibly expire worthless if the underlying security doesn't move in price, meaning that the money you spent on them would be lost and you would make no return. The negative effect of time decay on holding options contracts means that you'll need the underlying security to move a certain amount just to break even, and even further if you are to generate a profit.
Therefore, buying puts options is unlikely to be the best strategy if you are anticipating only a small drop in price of the underlying security, and there are other downsides too. This isn't to say that you should never simply buy puts, but you should be aware of how some of the downsides can be avoided through the use of alternative strategies.
There is a range of trading strategies suitable for a bearish outlook, and each one is constructed in a different way to offer certain advantages. An important aspect of successful trading is to match a suitable strategy to whatever it is you are trying to achieve on any given trade.
As an example, if you wanted to take a position on an underlying security going down in price but didn’t want to risk too much capital, you could buy puts and also write puts (at a lower strike) to reduce some of the upfront cost. Doing this would also help you offset some of the risk of time decay.
Another way to reduce the negative effect of time decay would be to include the writing of calls. You can even use strategies that return you an initial upfront payment (credit spreads) instead of the debit spreads that have an upfront cost.
Basically, bearish options trading strategies are very versatile. By using the appropriate one you cann't only profit from the price of the underlying security falling, but you also have an element of control over certain aspects of a trade like the exposure to risk or the level of investment required.
Disadvantages of Bearish Strategies
Although there are clear advantages to using bearish options trading strategies other than simply buying puts, you should be aware that there are some disadvantages too. Most of them usually involve a trade off in some way, in that there's essentially a price to pay for any benefit you gain.
For example, most of them have limited profit potential; which is in contrast to buying puts where you are limited only by how much the underlying security can fall in price. While this isn't necessarily a huge problem, because it's reasonably rare for a financial instrument to drop dramatically in price in a relatively short period of time, it does highlight that to get an extra benefit (such as limited risk) you have to make a sacrifice (such as limited profit).
In some respects, the fact that there are a number of different strategies to choose from is a disadvantage in itself. Although it's ultimately a good thing that you have a selection to choose from, it's also something of an extra complication, because it takes extra time and effort to decide which is the best one for any particular situation.
Also, because most of them involve creating spreads, that require multiple transactions, you will have to pay more in commissions. In truth, though, these disadvantages are fairly minor and far outweighed by the positives. The fact is if you can become familiar with all the various strategies and adept at choosing which ones to use and when, then you stand a very good chance of being a successful trader.
List of Bearish Strategies
Below is a list of the more frequently used strategies that are suitable for when you have a bearish outlook. There's also some brief information about each one: including the number of transactions required, whether a debit spread or a credit spread is involved, and whether it's appropriate for beginners.
You can get more detailed information on each one of these by clicking on the relevant link. If you would like additional help in choosing a strategy, then you can use our selection tool which you can find here.
This is a single position strategy that involves only one transaction. It's suitable for beginners and comes with an upfront cost.
Only one transaction is required for this single position strategy, and it produces an upfront credit. It isn't suitable for beginners.
This simple strategy is perfectly suitable for beginners. It involves two transactions, which are combined to create a debit spread.
This is relatively straightforward strategy, but it requires a high trading level so it isn't really suitable for beginners. A credit spread is created using two transactions.
This is complex and not suitable for beginners. It requires two transactions and can create either a debit spread or credit spread, depending on the ratio of options bought to options written.
This is fairly complicated and not ideal for beginners. A credit spread is created and two transactions are involved.
The bear butterfly spread has two variations: the call bear butterfly spread and the put bear butterfly spread. It's not suitable for beginners; it requires three transactions and creates a debit spread.
This requires three transactions to create a debit spread. It's not suitable for beginners due to its complexities.