Long Put Ladder Option Strategy
When to use: Long Put Ladder Strategy is used when the investor is moderately bearish on the stock and expects relatively low volatility. This strategy is an extension of the Bear Put Spread Strategy. In this case, the investor sells an additional put option.
How it works: In the long put ladder strategy you buy 1 in-the-money put option; sell 1 at-the-money put option and sell 1 out-of-the-money put option of the same underlying stock with the same expiry date. You believe that the market will be bearish until expiry.
For example: On 3rd September 2013, the share of IDFC Limited was trading at Rs. 80.00, you decide to buy an in-the-money put option with a strike price of Rs. 85.00 at a premium of Rs. 4.10. At the same time you sell an at-the-money put option with a strike price of Rs. 80.00 at a premium of Rs. 2.65 and an out-of-the-money put option with a strike price of Rs. 75 at a premium of Rs. 1.65.
Risk/Reward: In the long put ladder strategy, your maximum risk will be unlimited and you will start incurring losses when the underlying stock falls below the breakeven point (i.e. Rs. 69.80, calculated as: Sum of the strike prices of the two short puts – strike price of long put - net premium received). The maximum reward/profit which you stand to make from this trade will be limited.
If the price of IDFC Limited falls below Rs. 85.00 (i.e. the strike price for the long put option), you can exercise the long put option, but the price of the stock must fall below Rs. 80.90 (i.e. the strike price for the long put option minus the amount of premium) for you to exercise your long put option and make a profit.
Similarly, if the price of the share stays above Rs. 80.00 and/or Rs. 75.00 (i.e. the respective strike prices of the short put options) until expiry, you will retain partial or full premium amount. If however the price falls below Rs. 80.00 and/or Rs. 75.00, the buyer of put option may exercise his option. Once the price falls below Rs. 77.35 and/or 73.35 (i.e. the respective strike prices of the short put options minus the respective premium), the buyer of put option will start making a profit based on how far the stock price falls. From the perspective of the seller of the put (you), you will start suffering a loss once the stock price falls below Rs 77.35 and/or 73.35 (i.e. the respective strike prices of the short put options minus the respective premium).
The table below shows the net payoff of the long put ladder strategy at different spot prices on expiry:
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example IDFC’s put option contract is for 2,000 shares. Accordingly the net premium received will be Rs. 400 for 3 lots (i.e. 0.20*2,000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of put option, you will have to deposit a margin of Rs. 50,344.00 (i.e. Strike price * Lot size * 16.24%) for selling/writing 2 lots of IDFC’s put option. Note that the total value of your outstanding position in this case will be Rs. 3,20,000 (i.e. strike price * lot size).