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Commonly Used Put Option Strategies in Trading
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8 mins read
Put options are crucial in options trading because they provide flexible strategies for investors. These strategies allow traders to navigate different market situations, such as hedging risks, predicting asset price movements, or improving their trading strategies. Whether you're a beginner or an experienced trader, it's important to understand how put options can be used to achieve various investment goals.
This chapter will explore the key strategies involving put options, explaining their applications and significance in meeting different investment objectives.
Commonly Used Put Option Strategies
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Long Put:
A long put refers to a strategy where an investor purchases a put option contract with the expectation that the price of the underlying asset will decrease significantly before expiration.
The motivation behind a long put strategy is to profit from a decline in the price of the underlying asset. If the price of the asset falls below the strike price before expiration, the holder of the long put can sell the asset at the higher strike price, thereby realising a profit.
The maximum loss for a long put is limited to the premium paid to purchase the option. However, the potential profit is theoretically unlimited if the price of the underlying asset decreases significantly below the strike price.
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- Imagine an investor who holds a bearish view of Company XYZ's stock. He believes that the stock price, currently trading at ₹200 per share, will decline in the near future due to various factors such as weak earnings prospects or unfavourable market conditions.
- To capitalise on his bearish outlook, the investor decides to purchase a long put option contract on Company XYZ. By buying a put option with a strike price of ₹190 per share, he has the right, but not the obligation, to sell Company XYZ's stock at ₹190 per share, regardless of its market price, until the expiration date, which is 30 days from now.
- He pays a premium of ₹8 per share for the put option contract, amounting to ₹800 for the entire contract (₹8 premium * 100 shares per contract). This premium represents his maximum potential loss. If the stock price remains above the strike price of ₹190 per share at expiration, his put option will expire worthless, and he will lose the entire premium paid.
- However, if the stock price falls below ₹190 per share by expiration, his put option will have intrinsic value. He can exercise the option to sell Company XYZ's stock at the higher strike price of ₹190 per share, regardless of its market price. The resultant profit will be the difference between the strike price and the actual stock price minus the premium paid for the option.
- For the investor to break even on his investment, the stock price needs to drop below ₹182 per share (strike price minus premium) by expiration. Below this point, every decrease in the stock price adds to his profit potential.
A long put is, thus, a bearish strategy that provides flexibility and leverage for traders to capitalise on downward price movements in the market.
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Short Put:
The short put strategy involves selling put options with the expectation that the price of the underlying asset will remain stable or increase slightly before expiration. It's a bullish strategy that profits from time decay and a rise in the price of the underlying asset.
The primary goal of the short put strategy is to generate income through the premium received from selling put options. If the options expire worthless (out-of-the-money), the seller keeps the premium as profit.
The risk of the short put strategy is substantial. If the price of the underlying asset falls below the strike price at expiration, the seller may be obligated to buy the asset at a higher price than its market value. The maximum loss potential is unlimited, as the price of the underlying asset can theoretically decline to zero.
The breakeven point for the short put strategy is the strike price minus the premium received. As long as the price of the underlying asset remains above the breakeven point at expiration, the strategy will be profitable.
To manage risk, short put sellers may choose to buy back the put options before expiration if they anticipate a significant price movement in the underlying asset. Alternatively, they can roll the position forward by closing the current position and opening a new short put position with a later expiration date or different strike price.
Let's use the previous example but apply it to a short put strategy:
The investor is bullish on Company XYZ's stock. He believes that the stock price, currently trading at ₹200 per share, will either remain stable or increase slightly in the near future due to positive earnings prospects or favourable market conditions.
To capitalise on his bullish outlook, he decides to implement a short put strategy on Company XYZ. Instead of buying put options, he sells a put option contract with a strike price of ₹190 per share. By selling the put option, the investor receives a premium from the buyer and assumes the obligation to buy Company XYZ's stock at ₹190 per share if the buyer chooses to exercise the option.
Ultimately, he receives a premium of ₹8 per share for selling the put option contract, amounting to ₹800 for the entire contract (₹8 premium * 100 shares per contract). This premium represents his maximum potential profit. If the stock price remains above the strike price of ₹190 per share at expiration, the put option will expire worthless, and he will retain the entire premium received.
However, if the stock price falls below ₹190 per share by expiration, the put option will have intrinsic value, and the buyer may choose to exercise the option. In this case, he will be obligated to buy Company XYZ's stock at ₹190 per share, regardless of its market price. His profit will be reduced by the difference between the strike price and the actual stock price, plus the premium received for the option.
For him to break even on his investment, the stock price needs to drop below ₹182 per share (strike price minus premium) by expiration. Below this point, he may be assigned the stock, and his profit potential diminishes.
A short put strategy, thus, allows investors to profit from a stable or slightly increasing stock price while generating income from selling put options. It's a bullish strategy that provides flexibility and income-generation opportunities for traders in various market conditions.
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Protective Put:
Also known as a "married put," this strategy involves buying put options to protect an existing long position in the underlying asset. If the price of the asset declines, the put option provides downside protection by allowing the investor to sell the asset at the strike price, limiting potential losses.
Let's consider an example of a protective put strategy:
Riya owns 100 shares of Company XYZ, which she purchased at ₹150 per share. She is concerned about potential downside risk in the stock market due to uncertainties in the economy. However, she wants to retain ownership of Company XYZ's stock for the long term.
To protect her investment in Company XYZ while maintaining ownership of the stock, Riya decides to implement a protective put strategy. She purchases 1 put option contract on Company XYZ with a strike price of ₹140 per share. This put option allows Riya to sell her shares at ₹140 per share, regardless of the stock's market price, until the expiration date.
If the price of Company XYZ's stock falls below ₹140 per share, Riya's put option will have intrinsic value. She can exercise the option to sell her shares at the higher strike price of ₹140 per share, limiting her potential losses. This provides Riya with downside protection and helps mitigate the impact of a declining stock price on her investment portfolio.
Riya pays a premium for purchasing the put option contract. Let's say the premium is ₹5 per share, amounting to ₹500 for the entire contract (₹5 premium * 100 shares per contract). This premium represents the cost of insurance for Riya's investment in Company XYZ.
For Riya to break even on her investment, the stock price needs to decline by the amount of the premium paid (₹5 per share) plus the strike price (₹140 per share). Below this breakeven point, Riya's losses on her stock holdings will be offset by the profit from the put option.
A protective put strategy allows investors like Riya to protect their investment portfolios from downside risk while maintaining ownership of their assets. By purchasing put options, investors can hedge against potential losses in the stock market and safeguard their portfolios in uncertain market conditions. While there is a cost associated with purchasing put options, the benefits of downside protection and peace of mind can outweigh the expense for investors seeking to preserve capital and manage risk.
- Put Spread: Put spread strategies involve buying and selling put options simultaneously to create a spread. The two most common types of put spreads are:
- Bear Put Spread: This strategy involves buying a put option with a higher strike price and selling a put option with a lower strike price. It's used when the investor expects a moderate decrease in the price of the underlying asset.
- Bull Put Spread: The bull put spread is an options trading strategy utilised by investors who anticipate a moderate rise in the price of the underlying asset. This strategy involves selling one put option with a higher strike price while simultaneously purchasing another put option with a lower strike price, both having the same expiration date.
These are just a few examples of put buying strategies that investors can employ based on their market outlook and risk tolerance.
The choice of strategies in options trading in the Indian Market is influenced by the prevailing market trend. Bullish strategies are suitable during upward trends, bearish strategies are appropriate during downward trends, and neutral strategies are employed when the market is trading sideways.
What Is Leverage in Put Options?
Leverage is a key concept in options trading, including put options. Leverage refers to the ability to control a larger position in the underlying asset with a relatively smaller amount of capital by trading options. Put options offer leverage because they allow investors to gain exposure to the price movement of the underlying asset at a fraction of the cost of owning the asset outright.
Suppose an investor believes that the price of Company XYZ stock, currently trading at ₹100 per share, will decline in the near future. Instead of short-selling the stock, which involves borrowing shares and potentially facing unlimited losses, the investor decides to purchase put options on Company XYZ.
- If the investor buys one put option contract on Company XYZ with a strike price of ₹100 for a premium of ₹5 per share, the total cost of the trade would be ₹500 (₹5 premium * 100 shares per contract).
- Now, let's say the price of Company XYZ stock drops to ₹90 per share. The put option would be in-the-money, allowing the investor to sell the stock at the higher strike price of ₹100 per share.
In this scenario, the investor's profit from the put option would be ₹500 (₹100 strike price - ₹90 stock price - ₹5 premium).
Leverage amplifies both potential gains and losses in options trading. While leverage can magnify profits if the trade goes in the investor's favour, it also increases the risk of significant losses if the trade moves against them. Therefore, it's essential for options traders to manage risk carefully and be aware of the potential impact of leverage on their trading strategies.
Significance of Time Value in Put Options
Time value, also known as extrinsic value, is one of the components of an option's premium. It represents the portion of the option's premium that exceeds its intrinsic value, which is the difference between the strike price of the option and the current market price of the underlying asset (if the option is in-the-money).
In put options, time value reflects the amount that investors are willing to pay for the potential future movement of the underlying asset's price before the option's expiration date.
Here's why time value is crucial in put options:
- Risk Management for Buyers: Time value provides a buffer against potential losses for put option buyers. It represents the premium paid for the option beyond its intrinsic value, acting as insurance against adverse price movements in the underlying asset. The higher the time value, the greater the protection for the buyer, as it allows more time for the underlying asset's price to move in the desired direction before expiration.
- Profit Potential for Sellers: For put option sellers, time value represents the potential profit from selling the option. By selling put options, sellers collect premiums, which consist of both intrinsic value and time value. As time passes and the option approaches expiration, time value diminishes due to time decay, allowing sellers to potentially buy back the option at a lower price or let it expire worthless to retain the entire premium received.
- Flexibility in Trading Strategies: Time value offers flexibility for both buyers and sellers in implementing trading strategies. Options with more time value provide greater flexibility for adjustments, hedging, and speculation. Traders can adjust their positions, roll options forward to later expiration dates, or close positions early to capitalise on changing market conditions.
- Price Discovery and Market Sentiment: Changes in time value reflect market expectations about the future movement of the underlying asset's price. As time value fluctuates, it provides insights into market sentiment, volatility expectations, and investor behaviour. Traders monitor changes in time value to gauge market sentiment and make informed trading decisions.
- Expiration Dynamics: Time value plays a crucial role in the dynamics of option expiration. As options approach expiration, time value diminishes rapidly due to time decay, accelerating in the final weeks and days before expiration. Traders must consider time decay when managing their positions and deciding on the timing of their trades.
Final Words
Put options are a strategic asset for investors aiming to manage risk, speculate on market trends, and achieve their financial objectives through informed and disciplined trading. Successful options trading requires comprehensive research, a clear understanding of risk, and a well-thought-out trading plan. With these strategies, you can effectively leverage put options.
With this, we conclude this chapter and will explore differences between call and put options in the next.