In this strategy, one expects markets to go down. The strategy balances profit and risk.

Bear Spread - Put Strategy (definition)
A bear put spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying higher striking in-the-money put options and selling the same number of lower striking out-of-the-money put options on the same underlying security and the same expiration month.

Example:
Date: 28th July 2011
Nifty Value: 5485
  • Sell (write) one lot of 5300 Put (25 AUG 2011 expiry) at a premium of 42
  • Buy one lot of 5500 Put (25 AUG 2011 expiry) at a premium of 108.

66 Rs (108 - 42) per lot (3300 Rs) is debited from your account entering the above position. You will make profits if Nifty ends below 5434 (5500 - 66) at expiry (25 AUG 2011).

Below are the various profit/loss scenarios at expiry
  • Nifty ends below 5300 - Fixed profits of Rs 4600
  • Nifty ends between (5300 - 5434) - You will make profits ranging from (Rs 4600- Rs Rs 0)
  • Nifty ends between (5434 - 5500) - You will make losses ranging from (Rs 0 - Rs 3300)
  • Nifty ends above 5500 - You will make fixed losses of Rs 3300 (66 * 50)

If you are a smart trader, you will get opportunities before expiry to exit the bear spread strategy with decent profits even if Nifty does not fall below 5434.

(write:buy) ratio in the above example is 1:1 and the gap between write and buy contracts is 200 Points in Nifty. You can tweak the (write:buy) ratio and gap to build you own strategy based on your risk appetite.

Note: I did not include brokerage charges in the above example

Any views on this strategy are welcome. Let us know how it works for you.