Short Put Ladder
The short put ladder, or bull put ladder, is a unlimited profit, limited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience significant volatility in the near term.
|Short Put Ladder Construction|
|Sell 1 ITM Put|
Buy 1 ATM Put
Buy 1 OTM Put
To setup the short put ladder, the options trader sells an in-the-money put, buys an at-the-money put and buys another lower strike out-of-the-money put of the same underlying security and expiration date.
Unlimited Downside, Limited Upside Profit Potential
Maximum gain is limited to the initial credit received if the stock price rallies above the upper breakeven point but large unlimited profit can be achieved should the stock price makes a dramatic move to the downside below the lower breakeven point.
The formula for calculating profit is given below:
- Maximum Profit = Unlimited
- Profit Achieved When Price of Underlying < Total Strike Prices of Long Puts - Strike Price of Short Put + Net Premium Received
- Profit = Lower Breakeven - Price of Underlying
|Short Put Ladder Payoff Diagram|
Maximum loss for the short put ladder strategy is limited and occurs when the underlying stock price on expiration date is trading between the strike prices of the put options bought. At this price, while both the short put and the higher strike long put expire in the money, the short put is worth more than the long put, resulting in a loss. The loss can be calculated using the formula below.
The formula for calculating maximum loss is given below:
- Max Loss = Strike Price of Short Put - Strike Price of Higher Strike Long Put - Net Premium Received + Commissions Paid
- Max Loss Occurs When Price of Underlying is in between the Strike Prices of the 2 Long Puts
There are 2 break-even points for the short put ladder position. The breakeven points can be calculated using the following formulae.
- Upper Breakeven Point = Strike Price of Short Put - Net Premium Received
- Lower Breakeven Point = Total Strike Prices of Long Puts - Strike Price of Short Put + Net Premium Received
Suppose XYZ stock is trading at $40 in June. An options trader executes a short put ladder strategy by sellng a JUL 45 put for $600, buying a JUL 40 put for $200 and a JUL 35 put for $100. The net credit received for entering this trade is $300.
Let's say XYZ stock remains at $40 on expiration date. At this price, only the short JUL 45 put will expire in the money with an intrinsic value of $500. Taking into account the initial credit of $300, buying back this put to close the position will leave the trader with a $200 loss - which is also his maximum possible loss.
In the event that XYZ stock rallies and is trading at $45 on expiration in July, all the puts will expire worthless and the trader's profit will be the initial $300 credit received when entering the trade.
However, if the stock price had dropped to $25 instead, all the put options will expire in the money. The long JUL 40 put will expire with $1500 in intrinsic value while the long JUL 35 put will expire with $1000 in intrinsic value. Buying back the short JUL 45 put will only cost the options trader $2000 so he still have a gain of $500 when closing the position. Together with the initial credit of $300, his total profit comes to $800. This profit could have been greater if the stock had dived below $25.
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).
The following strategies are similar to the short put ladder in that they are also high volatility strategies that have unlimited profit potential and limited risk.
Long Put Ladder
The converse strategy to the short put ladder is the long put ladder. Long put ladders are employed when little or no movement is expected of the underlying stock price.
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