A basic and commonly implemented option strategy is the Long Put Option Strategy
When to use: When you are Bearish and anticipate the stock / index to rise.
How it works: Suppose, you are bearish on ICICI Bank stock on 16th August 2013, when the stock trades at Rs. 830. You buy a put option at a premium of Rs. 36, expiring 26th September 2013 with a Strike Price of Rs. 860.
Risk / Reward: If the price of ICICI Bank stock falls below Rs. 860 (i.e. the strike price), you can exercise your option, but the price of the stock must fall below Rs. 824 (i.e. the strike price minus the premium), for you to exercise your option and make a profit. In other words, your break even or the price below which you will make any profit in this scenario will be Rs. 824 (i.e. Strike Price – Option Premium).
If however, the stock price does not fall below Rs. 860 (i.e. the strike price) until the date of the expiry, you will not be able to exercise the option and the option will lapse worthless in which case you will lose the option premium of Rs. 36. The Chart below illustrates your payout assuming that you unwind your position on these dates and prices:
* Position unwinding in the table above refers to “Exercising the Option” as opposed to squaring off – Look Below.
Accordingly, your risk is limited to the option premium of Rs. 36 (i.e. Rs. 36 is the maximum loss you can suffer on this contract). Your reward is unlimited and will depend on how much the price falls below Rs.824 at the time you unwind your position.
Note: The example and calculations are based assuming a single share. In reality options are based on lots of many shares. For example a single ICICI Bank option contract is for 250 shares. Accordingly the premium will be Rs. 9,000 for a single lot (i.e. 36 *250) in our example.
In Practice: In practice, traders do not wait until expiry to unwind their position. You (can) square off your position before the expiry of the contract. This is done by selling the same number of put options which you purchased of the same underlying stock and same expiry date. So for example if you purchase 1 put option contract of ICICI Bank (lot size 250 shares) at a strike price of Rs. 860 and a premium of Rs. 36 (i.e. Rs. 9,000 for the whole contract) expiring 26th September 2013; you can square off your position by selling the same put option contract (i.e. strike price Rs. 860, expiring 26th September 2013). The difference between the premium at which you bought the Options, and the premium at which you sold, will be your profit or loss.
In addition to squaring off, you can also exercise your Option on or before the expiration date, in which case your profit/loss will be calculated based on the difference between the closing market price on the day you exercise the Option and the strike price. If you do nothing until expiry, your position will be settled by the stock exchange on expiry.
How to use the Long Put Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Long Put Option Strategy.