Option Strategies for a Downturn

If there is one lesson that investors should learn from market history over the past several decades, it is that the best time to buy stocks is when the market is tanking. Unfortunately, very few have the conviction to buy in the middle of a wave of panic selling.

If making a complete commitment to buy is not in the cards for you, then one option strategy—selling puts—provides an alternative. Selling puts may actually be easier for the individual investor to stomach.

Buying in a Downturn

Market history suggests that a contrarian approach often works better. After the bear market in the early 1970s, buyers were rewarded. Investors made lasting gains by buying during a severe recession in the early 1980s. After the financial crisis of 2008, stock buyers won big over the next decade. Within months of the crash of 2020, many investors made record gains in a short time. For those who buy during the 2022 bear market, the same is likely to apply.

Basics of Put Options

A put option gives the buyer of that option the right to sell a stock at a predetermined price, known as the option strike price. Buyers of put options are making bearish bets against the underlying company. The price you would pay for that put option will be determined, among other things, by the length of time you want the option to last. The longer the time to expiry of the option, the more expensive it is.

When selling put options, the reverse is true. A seller of put options is taking on the obligation to buy the underlying stock at a predetermined price. Notice the difference in buying and selling puts: When you buy a put, you have the right but not the obligation to sell the option. If you don’t want to sell the stock at the option strike price of $50 because the shares are trading out-of-the-money at $60, for example, you can simply let the option expire and only lose the premium paid.

When you sell puts, you are required to buy the shares if the buyer of the puts decides to sell them. So, by selling put options, you are taking on more risk than the put buyer. You are entering into a contract where you have an obligation, rather than a right to buy the stock. This information should be well-known to investors who have studied options basics.

Put Selling in a Downturn

When markets are declining, selling put options can be a useful tool for the individual investor. However, this is a bullish-to-neutral strategy that involves risk. If the underlying stock moves higher (bullish) or stays about the same (neutral) during the life of the option, the put writer will make their maximum profit, which is the premium collected. However, if the underlying stock falls substantially, and in bear markets this is a distinct possibility, then the put writer can be left holding substantial losses.

Markets are often more volatile during bear markets. Selling options when there is more volatility implies that sellers will get a higher price due to rising premiums. Sophisticated options traders like to sell puts in hopes of pocketing the premium income. However, long-term investors could look at selling put options as a way to buy shares in businesses that they like at a possibly lower cost. Legendary investor Warren Buffett has used similar strategies in the past.

The best time to buy stocks is when markets are declining. Yet many investors simply don’t have the emotional wherewithal to do so. Selling puts is one way to alleviate the problem. This type of strategy has been successful enough that put-selling exchange traded funds (ETFs) are now available for the S&P 500.

Example of Option Strategies for a Downturn

Let’s say you’re a fan of Company XYZ, but you’re still on the fence about what the market is going to do. You would like to own 500 shares of the company in your portfolio. With a current price of $50, that will cost you $25,000. Instead, you can sell five put contracts (one contract = 100 shares). For example, you could sell next month’s $45 put options on XYZ for approximately $3.

By doing so, you will pocket $1,500 in premium income from the sale (500 shares at $3 each). For purposes of this article, we will ignore commissions because they are often low, although they should still be considered. Because you wrote this option, you must buy 500 shares of XYZ at any time until expiration for $45. If you must buy the stock, your net costs without commissions will be $42 a share because of the option premium income.

By selling the put, you went from needing to put up $25,000 to buy the shares to collecting $1,500 in premiums. If shares in XYZ declined below $45, you would have the shares “put” to you. However, your cost basis is $22,500 less the $1,500 you collected in premiums, or a net cost of $21,000.

Drawbacks

Selling puts and option trading in general can be risky. If shares in XYZ or any company that you sell put options on decline significantly, you will be sitting on losses. Option premiums will just reduce the losses. Using the above example, if shares of XYZ declined to $25 and you had the shares put to you, it would require you to buy the shares for $45, which is the strike price. The premium of $3 reduces the per-share cost to $42, but you still will experience significant losses (42 – 25 = 17). You would have bought shares that are now worth $25 for $42. Conversely, suppose the stock price had continued to rise. Then, the put seller will miss out on further upside that could have been achieved above and beyond the option premium.

Selling Puts Intelligently

Because they are derivative instruments, the buying and selling of options should be handled with extra care. The sale of a put firmly obligates you to buy the underlying stock if the counterparty (buyer of the put) requires you to do so. Therefore, only sell puts on stocks that you would be comfortable owning for the long term. One tactic that could help to manage risk is the seagull option strategy, which involves either two call options and a put option or two puts and a call. Meanwhile, a call on a put is called a split option.

For the vast majority of investors, selling puts should only be considered as a way of potentially buying shares down the road. Let earning the option premium be a fallback if you don’t get a chance to buy the stock for less. This type of thinking will significantly reduce the probability of selling puts for the wrong reasons and losing substantial amounts of money.

The Bottom Line

Market history has shown that the best time to buy stocks is when the market is in decline. But many investors lack the conviction to buy in such a panicked market. But if committing to buy in a bear market is not right for you, then the option strategy of selling puts on selected stocks gives an alternative to more risk-averse investors that still may allow them to benefit from buying on the market dip.