Why Bear Markets Are Best For Options Trading?

Why Bear Markets Are Best For Options Trading?

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Why Bear Markets Are Best For Options Trading?

If you are going to be an options trader, bear markets and market crashes are realities that cannot be avoided. While alot of options traders cringe at the idea of a bear market or market crash, real options traders actually celebrate it and the elite few actually make their fortunes during those times. Yes, you may be surprised to know that bear markets or market crashes are actually the best times to make money through options trading! In fact, utilizing the exact same options strategies, you will more often than not make significantly more profit during a bear market or market crash than during a normal bullish trending market. In fact, you might be able to return more than 5 times the normal profit on some options strategies during bear markets! Why is that so?

Reason 1: Higher Volatility Increases Directional Profits!

One of the main factors affecting options pricing (See Options Greeks) is Implied Volatility, Vega. Basically, this means that if the price of the underlying stock is expected to move alot in the near future, the price of its options increases even without an increase / decrease in price of the underlying stock. Yes, the expectation of greater stock price volatility actually makes options more valuable because such a possibility increases the chances of making a greater profit through options. Conversely, when a stock is expected to be stable without any big movements in the near future, its implied volatility drops and therefore its value even without any movement in the price of the underlying stock. As such, all else equal, you are always going to make more profit buying a put option during a bear market than a call option during a bull market on the exact same amount moved on the underlying stock because of this factor. That's right, if you bought a call option during a steady bull market and the underlying stock moved up by let's say $5, you would actually make lesser profit than if you bought a put option during a bear market and the underlying stock moved down by the same $5. Why is this so?

That's because Implied Volatility, defined by the options greek Vega, tends to surge strongly during bear markets, lifting the extrinsic value of all options and tends to drop drastically, depressing the extrinsic value of all options during bull markets! Stock prices are more volatile and more expected to make bigger moves than they do in stable bull markets. As such, when you buy put options during a bear market and the stock drops by $5, you are not only profiting from the $5 move but also from increased extrinsic value through an increased, usually a surge, in Implied Volatility! So, you will most often be making a profit of $5 + increased extrinsic value in a bear market, rather than $5 - decrease in extrinsic value most of the time in a steady bull market.

Reason 2: Higher Volatility Increases Spread Profits!

If you are a fan of collecting extrinsic value through credit spreads or other such options writing based options strategies, you would no doubt experience a sometimes dramatic increase in profitabilty when such options strategies are executed during a bear market or market crash. In fact, my favorite calendar spread returned about 5 times more profit in 2008 than it did in 2007 or before. That is again due to higher volatility lifting the Implied Volatility of options resulting in higher extrinsic values. So if your options strategy revolves around collecting extrinsic value, then you would no doubt experience increased profitability during bear market due to the increased extrinsic value through an increased Implied Volatility, no rocket science there.

Reason 3: Bear Markets Move Fast and Hard!

Ever heard the saying that "Bulls take the stairs while Bears jump out of the window?". Yes, stocks typically decline in value much much faster than it gains them. In fact, every market crash has been able to oliterate stock value that took years to build up within just a relatively short period of time. The 2008 market crash took away in just one year all of the value build up over the 4 years preceding the crash. Looking at this phenomena from an options trader's point of view, this also means that a move that previously took months to complete during a bull market could take only weeks or days to complete in the other direction using put options, making more profit within a shorter period of time especially if you are pursuing a directional based options strategy or even simply going long put.

Why Bear Markets Are Best for Options Trading - Conclusion

Of course, bear markets are only best for options trading versus bull markets when you are first able to apply the correct options strategy in each case. If you keep applying options strategies on the wrong side of the market, you won't be making any profit whether in a bull market or a bear market. So, if you are able to apply the correct options strategies on the correct side of the market consistently, you might find that bear markets actually reward you more than bull markets would.

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