Buying Index Puts
The index long put is the simplest strategy to use in index options trading and the implementation involves the purchase of an index put option.
|Index Long Put Construction|
|Buy 1 ATM Index Put|
The options trader employing the index long put strategy believes that the underlying index level will fall significantly below the put strike price within a certain period of time.
Unlimited Profit Potential
Since they can be no limit as to how low the index level can be at the option's expiration date, there is no limit to the maximum profit possible when implementing the index long put strategy.
The formula for calculating profit is given below:
- Maximum Profit = Unlimited
- Profit Achieved When Index Settlement Value < Index Put Strike Price - Premium Paid
- Profit = Index Put Strike Price - Index Settlement Value - Premium Paid
|Index Long Put Payoff Diagram|
Risk for the index long put strategy is capped and is equal to the price paid for the index put option no matter how high the index is trading on expiration date.
The underlier price at which break-even is achieved for the index long put position can be calculated using the following formula.
- Breakeven Point = Index Put Strike Price - Premium Paid
XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will retreat in the near future, an options trader purchases an six-month XYZ index put with a strike price of $400 expiring in December for a quoted price of $4.00 per contract. With a contract multiplier of $100, the cost of the index put option comes to $400.
Suppose XYZ Index dropped to 380 in December and the trader's DEC 400 XYZ index put expires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option will have an intrinsic value of $20 and exercising this option will give the trader a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the cost of the option itself, which is $400, the trader's net profit comes to $1600.
Suppose XYZ Index went up to 420 in December and the trader's DEC 400 XYZ index put expires out-of-the-money. At settlement value of 420, the DEC 400 XYZ index put option will expire worthless with zero intrinsic value. The trader's net loss is equal to the amount paid for the index put option which is $400.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).
Out-of-the-money Index Puts
Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.
In-the-money Index Puts
Index puts can also be used to protect a portfolio against a declining market without the need to liquidate any stock while at the same time enable the portfolio to participate and benefit from a rising market.
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