How do you use put options to profit from a bear market?

Finding profitable trading strategies during a bear market is often challenging. Experienced traders, however, can use option contracts to profit in almost any economy or market situation. One options traders profit in a down market involves employing the use of put options. Whether the contract is purchased for protection, called a hedge, or sold as a play on falling prices, a put option has several advantages in a bear market when used correctly.

Conservative options traders can use put options in a bear market to protect against losses on a position they currently own, called a long position. For example, if a trader owns 100 shares of ABC stock at a price of $50 per share, he or she can purchase a put option with a strike price of $55 as a form of insurance on the investment. In this scenario, if the stock price in a bear market moves below $50, the trader can exercise the put option, capturing a price higher than the market and securing a $5-per-share profit. Granted, the purchase price of the put option, called the premium, needs to be factored into the net profit calculation.

A riskier trade with potentially high profits, called a naked put, is another trading strategy to use in bear market trading. Not only do traders have the opportunity to pocket a nice premium from the sale of such puts, they can use this strategy to acquire shares of a stock at a great price. Say ABC stock is trading at $50 and falling in a bear market. The trader can sell a put contract, equal to 100 shares of the underlying stock, with a strike price of $40 and collect a nice premium. If the price falls below $40, the put is likely to be exercised, meaning the trader is obligated to purchase 100 shares of ABC at $40. His or her total cost for the shares is adjusted to include the premium collected, making this strategy a nice way to obtain stock at lower prices. The key to this trade's profitability lies with the likelihood the stock turns around and can be sold at a higher price later.

Bear markets can take a toll on portfolios, so finding a way to make money in the meantime by selling put options can seem like a worthwhile trading strategy. In reality, as bear markets, or any market for that matter, are unpredictable, traders should only consider selling puts on stocks they would not ultimately mind owning. Likewise, consider strike prices only if you see value at that price. A strategy to collect only premiums as profit is much easier and safer to accomplish through selling covered calls, especially during a bear market.