Underlying Strategy

Extremely Bearish

When a trader is completely bearish on the instrument, but wants to cap his downside risk. This Strategy gives unlimited profit on the downside and a limited loss on the upside.

Methodology

The trader buys a Put option of the strike price, assuming that the instrument shall expire at or below the strike price at the time of its expiry.

Risk Profile:

This is a low risky setup as the loss is limited.The risk-reward ratio is the best in these kind of strategies.

However the probability of successful trades is extremely less in  buying OTM options as most of these options expire worthless.

Margin requirements are low for this strategy.

Calculations:

Max Potential Profit: Strike Price-Cost of PE

When: The stock goes to zero.

Max Potential Loss: Net premium paid.

When: If stock expires at or above the strike price.

Breakeven at expiration: The strike price – Cost of the PE

Impact with passage of time

The PE price reduces with the passage of time, assuming the instrument price remains constant. Hence time decay works against this strategy.

Illustration 

Suppose the trader is extremely bearish on TataMotors and expects that TataMotor’s stock price would fall in the next few weeks..

In order to capture the move, he has two options. He can take a short position in TataMotors futures or he can buy a put option.Since taking positions in futures require significantly higher margin than buying  options and also has a risk of unlimited losses, the trader decides to buy a PE. In this case his risk is limited as he will only pay the premium for the put option, and he will have unlimited profits if the position goes in his favor.

TataMotors is currently trading at 453. The trader decides to buy 1 lot PE of strike price 430 of near month expiry, paying a premium of Rs. 3.5

Hence the breakeven price for this strategy shall be Rs.( 430-3.5=426.5). Note that the PE shall itself be profitable after the price crosses 430 at the time of expiry, but as the trader has already paid Rs. 3.5 for the option, it needs to recover that cost in order for the strategy to turn up a profit.

Now let us consider different scenarios at the time of expiry.

Stock closes at Rs.440.

Loss= (Net premium paid)*Lot Size

Value of the PE shall be 0

Hence Loss=3.5*1500

=Rs.5250

Stock Closes at Rs. 415

Profit=(Strike Price-Expiry Price-Net premium paid)*Lot Size

= (430-415-3.5)*1500

=(Rs.17500)

Stock closes at Rs. 400

Profit=(Strike Price-Expiry Price-Net premium paid)*Lot Size

= (430-400-3.5)*1500

=Rs.(39750)

Thus, unlimited profit at a risk of Rs. 5250 !!