Using Puts To Make Money In A Bear Market

Obviously no one knows if the market is at the beginning of a new bear market phase for the stock market, but one thing is for sure: if you would like to hedge yourself against the possibility that July 2011 marked the beginning of a downtrend, stock options–specifically put options–offer many opportunities for protecting yourself against losses. In this article Stock Options Explained will cover the simplest one of all: simply buying puts on stocks that you own.

Investors and short-term traders often attempt to use the outright purchase of put options to make money in a bear market or to protect their stock investments against potential losses. Either way, one favorable aspect of purchasing puts is that your risk is completely defined; in other words you can lose no more on a long put option than the purchase price that you pay for it. Of course, if the market does not reverse as you fear you could very well lose the entire purchase price of your put options. In this case presumably the appreciation you see in the stocks in your portfolio, against which the puts were meant to function merely as a hedge, will outweigh the losses you experience with your put contracts.

If the value of a given stock in your portfolio does fall in value though, the purpose of the purchase of your put contracts is to provide you with some profits to offset the paper losses you are experiencing with the stock. The idea here is that the puts are relatively short-term investments and you are not pessimistic enough to sell your stock positions outright. It has to be said– sometimes simply selling is a better strategy than trying to construct a hedge and augment it with hope.

The way the mechanics of this trade would work is that when you buy shorter-term puts, say with one to three months until expiration on them, most likely at the money or out of the money, you can either hold until expiration or until you suspect that the downward move is finished. Note that if the downturn is prolonged, you could potentially buy a whole series of puts against your long stock positions, though again if the market is experiencing a prolonged downtrend you would be thinking about selling those positions instead.