Use Index Options To Grow Your Portfolio When The Stock Market Is Falling

The good news is you can use index options to make money during bear markets.

The bad news is it's not easy.

I've mentioned that index options buyers have a hard time profiting on options because they have to be right on three factors. They must correctly forecast:

1. The direction of the market (up or down).
2. The magnitude of the move (how far the stock must move to go above the strike price).
3. The time that it will take for the market to move as far as he thinks it will move (the move must happen before the option contract expires).

A small investor can buy specially selected index options at certain times to maximize his chances of profiting from a falling stock market.

Here's how you can be right on all three factors.

By the way, I typically use a broad market index ETF like the S&P 500 SPDR (SPY). You can use a Dow Jones Index ETF. Some people like to use the NASDAQ (QQQQ) because of higher volatility.

The examples on this page use data provided by the iVolatility Basic Calculator and Yahoo! Finance (These links open in a new window)

Nail the Market Direction

Only enter the trade (buy the put option) after the market has signaled its move downward.

Use a simple trend following strategy like the 50-day and 200-day moving average.

You can either buy the put options when

• The market price (I'm talking about S&P 500 SPDRs) is closes more than 5% below its 200-day moving average;
• Or, when the 50-day moving average crosses below the 200-day moving average. This is also called the "death cross."

The disadvantage of using a trend following signal is that implied volatility will be higher (since the stock market is already moving downward) and you will end up paying more for the option.

Nail the Magnitude

The options seller keeps your money even though you are right on the market's direction because the price has to drop below the strike price and exceed the amount you paid in time value.

You nail the magnitude by buying deep in-the-money put options.

The deep in-the-money put option will have high delta, so ANY movement in the underlying's price movement will result in a near corresponding change in put option premium.

In-the-money put options have intrinsic value.

Options with the same expiration date will have less time value the farther they are in-the-money.

Here's an example:

SPY is currently trading at 103.

A 6-month SPY 90 put has no intrinsic value. Its $4.63 option premium is made up entirely of time value.

A 6-month SPY 118 put has $15 of intrinsic value. Its $18.05option premium has only $3.05 of time value.

A 6-month SPY 133 put has $30 of intrinsic value. Its $31.51 option premium has only $1.51 of time value.

Buying deep in-the-money puts cost more but results in squeezing out the time value, so you lose less time value with each passing day.

Give Your Index Options Time To Make Money

You know that you lose the most time value as the index option approaches expiration, so you want to buy longer dated options.

There's another reason.

You need to give the stock market time to make its downward move.

Buying a put option with a near expiration increases the probability it will expire worthless.

You can buy index options with expiration dates as far out as two-and-a-half years.

I'd buy put options with at least 6-months of life. But probably no more than 1-year.

Most bear markets make their biggest moves inside of 1-year.

You also need to worry about volatility skew. The longer dated options have higher implied volatility.

How Many Contracts?

hese are long put options. You can buy as many put option contracts as your personal risk allows.

Closing The Position

Close the position when the option is about to expire.

Enter into another long put position if your entry signal still exists (i.e, the 50-day moving average is still below the 200-day moving average).

You should also close your open put positions if the market reverse its trend.

This is signaled when the market closes more than 5% above the 200-day moving average, or when the 50-day average crosses above the 200-day average (also called the "golden cross").

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