Options being a non-linear instrument can help investors/traders in multiple ways and here are some of the simple strategies to be deployed in a falling market.
One of the ways investor’s uses options is for Hedging. Market corrections are fierce and steep and to protect the downside investors are at times willing to buy protection with a premium outflow i.e. at a cost.
Buying Puts is a simple strategy where an At the Money put is bought on the Index like Nifty with a notional value of the portfolio adjusted for portfolio’s beta.
This is a fairly expensive strategy but the protection is open for an unlimited downside and for the time period of protection the investor doesn’t need to bother much about any steep correction.
Deploying spreads like a Bear Put Spread, Bear Call Spread, etc. may be a better choice if the hedging is intended only up to a given level. For example Mr. A wants to protect his portfolio for any downside up to 9700 on Nifty where he’s confident of the Index reviving.
In this case, Mr. A doesn’t need to pay the premium of unlimited downside by buying a simple put and can reduce the premium outflow by deploying a spread which will cost lower than a long put. The trade-off is an open risk below the lower strike of the spread.
Hedging comes with a cost and no matter the portfolio falls or not, you are certain to spend the cost of hedging out from your pocket. This is not so lucrative to few investors and instead, they choose to generate some additional returns on the portfolio to compensate the downtrend.
To achieve this, covered calls can be deployed on stocks in the portfolio. Calls of stocks held in portfolio are sold with strikes at key resistance levels. This generates some returns with very limited risk.
If the stock moves up, the investor gets some returns in the stock till the strike plus the premium received and as he’s already holding the stock it can be delivered against the sold call.
In an event where the stock doesn’t move up, there is an additional return in the portfolio of premium received from the sold call option.
For traders expecting an immediate correction and wants to benefit from that, Long put can be a simple strategy to deploy. Predicting a market downside and using options to trade is more rewarding than predicting an upside.
Volatility increases in the case of a fierce down-trend and long options are positive volatility which means that put options will increase in value due to the market correction and will additionally increase due to the rising volatility, making it more lucrative and naturally rewarding to trade corrections.
A slow and gradual downside comes with a lot of Theta decay in the bought single options for eg. Long Puts. Hence, the idea is to reduce some of the theta decay by selling another option.
In these situations, buying a spread may be more beneficial than buying a single put option. This can be achieved by deploying one of the few strategies like Bear Put Spread, Bear Call Spread, Put Ratio Back-spread, Ratio Spreads, etc.>
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