The index short put strategy is a bullish strategy designed to earn from the premiums for selling the index put options with the hope that they expire worthless.
|Index Short Put Construction|
|Sell 1 ATM Index Put|
The options trader employing the index short put strategy expects the underlying index level to be above the put strike price on option expiration date.
Maximum profit is limited to the premiums received for selling the index puts.
The formula for calculating maximum profit is given below:
As the index level could fall dramatically, there is virtually no limit to the loss sustainable should the index level plummets drastically.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the index short put position can be calculated using the following formula.
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 rise moderately in the near future, an options trader sells a 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 premiums received for selling the index put option comes to $400.
Suppose XYZ Index dropped to 380 in December and the DEC 400 XYZ index put expires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option will possess an intrinsic value of $20 and upon assignment of this option, the trader is required to pay a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the premium received for selling the option, which is $400, the trader's net loss comes to $1600.
Suppose XYZ Index went up to 420 in December and the 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 profit is therefore equal to the amount received for selling 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 (+$4.95 per trade).
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