Strategies for the crashing market
This year is a wonderful time to short the market. During the pandemic the Fed has been pumping money into the market, and it was clear that the huge rally from March 2020 to December 2021 was nothing but a bubble. It was also obvious that the rally would be reversed by the turn from Quantitative Easing to Quantitative Tightening. Since just about all assets are falling, shorting the market is a very low risk play. The question of timing the trades will not be discussed here (January, March, May and August have been the best entry points). We look into how options can be used for shorting.
Put debit spread
When the market crashes, shorting indices (S&P 500, NASDAQ, Dow 30 and Russell 2000) or their proxies (exchange traded funds SPY, QQQ, DIA and IWM) is less risky than shorting individual stocks. That's what I learned (among many other things) from John Carter. Using put options instead of shorting stocks requires less capital. A further reduction in the capital requirement is achieved by using put debit spreads (their effect on buying power is zero).
Denote the price of a put with a strike We know that increases with (you have to pay more for the right to sell at a higher price). A put debit spread strategy has been discussed earlier. It consists of two put options (sorry for the notation change): buy a put with a higher strike and sell a put with a lower strike The initial outlay is Let be the stock price at expiration The max profit is and it is positive if The max loss is
The payoff is illustrated in Figure 1.
Call credit spread
A call credit spread is a strategy consisting of two call options: buy a call
1) Case
2) Case
3) Case
Comparison of the two strategies
The above discussion is summarized in Figure 1. Both strategies can be used if the outlook is bearish. Here we indicate two situations when one is preferred over the other.
Situation 1. Following unexpected bad news, the market falls a lot in one day and it is clear from macroeconomics that it will continue to go down for some time. If prior to the fall there was a healthy rally, it didn't make sense to buy a put. Right after the fall volatility increases, so puts become expensive. Buying a put debit spread is appropriate because volatilities from the long and short legs of the spread offset each other and one can increase the potential gain by selecting the strikes
Situation 2. A different approach is appropriate if a strong oneday fall is expected and any further developments are hard to predict. In this case selling a call credit spread with close expiration is recommended. This allows the investor to take advantage of the time decay. The strikes are selected above the current price
Mathematical approach to evaluating strategies
This will be explained using call credit spreads
Step 1. The payoff from a long call, neglecting the price
Step 2. What the long party gains, the short party looses, so the payoff from the short position (this time neglecting the credit received) is
Step 3. Let
Evaluating this expression for different price intervals gives the next table:
if 

if 

if 
Step 4. Adding the premium received
if 

if 

if 
Exercise. For a long put the payoff is
The pictures have been produced in Mathematica with
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