Case 045Option strategies and trade ideasWarm up

Tadoba Tractors is at Rs 500. A client sells the one-month 480 put at 15 and buys the 450 put at 6. What are the maximum profit, maximum loss and breakeven, and how does the position compare with owning the stock?

The situation

A broking client is mildly positive on Tadoba Tractors, at Rs 500, ahead of the monsoon sales season, but does not want to tie up the cash to buy the shares. Her dealer suggests a bull put spreadSelling a put and buying a lower-strike put with the same expiry. It collects a net premium and caps the loss at the gap between strikes, less that premium.: sell the one-month 480 put at Rs 15 and buy the one-month 450 put at Rs 6. The lot size is 1,000 shares.

Before she agrees, she asks three things: the most she can make, the most she can lose, and the price at which she breaks even, and how this differs from simply buying the stock.

Your task

Work out the maximum profit, maximum loss and breakeven per share and per lot, and compare the payoff with owning the stock.

Quick check

What are the maximum profit, maximum loss and breakeven per share?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

She keeps at most Rs 9 a share, can lose at most Rs 21, and breaks even at Rs 471. Per lot of 1,000 that is Rs 9,000 at best and Rs 21,000 at worst. Unlike the stock, the spread makes money even if Tadoba falls up to 5.8%, but its gain stops at Rs 9 however far the stock rises, and it risks Rs 21 to make Rs 9.

Step 1What do the two legs do together?

Selling the 480 put is like selling an insurance policy on Tadoba below 480: she collects Rs 15 and pays out if the stock falls below the strike. Buying the 450 put is reinsurance: she pays Rs 6 so that, below 450, someone else covers her. The net is a credit of Rs 9 a share, kept in full if Tadoba finishes above 480, and a loss that grows rupee for rupee between 480 and 450 and then stops, because below 450 the bought put pays her exactly what the sold put costs her. The position is a bet that Tadoba does not fall much, rather than a bet that it rises.

Step 2What are the profit, the loss and the breakeven?

Take the three regions in turn. Above 480 both puts expire worthless and she keeps Rs 9; below 450 she pays 30 on the spread between strikes and keeps the Rs 9, a loss of Rs 21; in between she loses one rupee for every rupee below 480, so she breaks even at 480 less 9, Rs 471. At 470 she is down Rs 1, at 460 down Rs 11. Per lot of 1,000 shares the best case is Rs 9,000 and the worst Rs 21,000, and the broker will block margin roughly equal to the worst case for the month.

Bull put spread against the stock, Rs per share at expiry-50-25+250400450480500550600stock bought at 500breakeven 471max profit +9: the credit keptmax loss -21sell 480 putbuy 450 put
The bull put spread earns its Rs 9 credit anywhere above 480, breaks even at 471 and loses at most Rs 21 below 450, while the stock bought at 500 gains and loses without limit in both directions.
Tadoba at expirySold 480 putBought 450 putCreditSpread P&LStock P&L from 500
420-60+30+9-21-80
450-30+0+9-21-50
471-9+0+9+0-29
480-0+0+9+9-20
500+0+0+9+9+0
550+0+0+9+9+50
Per share at expiry: the spread beats the stock everywhere below about 509, and the stock wins above it.
Step 3How does this compare with owning the stock?

Owning Tadoba at Rs 500 breaks even at Rs 500, makes Rs 50 if it rises to 550 and loses Rs 50 if it falls to 450. The spread breaks even Rs 29 lower, at 471, and wins against the stock everywhere below about 509, but it gives up everything above that, and it risks Rs 21 to make Rs 9. If outcomes were all or nothing, she would need to be right about 70% of the time just to break even, so the trade is only as good as the view that Tadoba stays above 471. The trade suits a view that Tadoba holds steady; for a view that it rallies, the stock or a call spread is the better fit.

State the limits. The figures are at expiry; before then the spread's value moves with volatility and time, and a sharp fall early in the month shows a mark-to-market loss close to the maximum even if Tadoba later recovers. If the stock settles between 450 and 480, physically settled single-stock options may oblige her to buy shares at 480, so she should know the settlement rule and have the cash. Brokerage on two legs and the margin blocked for the month reduce the effective return on the Rs 9 credit.

Where candidates lose it

The common loss is quoting the sold put's Rs 15 as the maximum profit and forgetting the Rs 6 paid for protection, or quoting the full 30-point strike gap as the maximum loss and forgetting the credit already received. Net the premiums first, then everything else follows.

The second is calling the spread a safer way to own the stock. It is a different bet: it is paid for the stock not falling, and it gives up the rally. A candidate who notices that the client risks Rs 21 to make Rs 9 has seen the trade from the client's side.

What the interviewer asks next

  • How would the trade look as a bull call spread with the same strikes, and why should the two cost about the same?
  • Tadoba falls to 470 in the first week. What are her choices?
  • Why does the broker block margin roughly equal to the maximum loss, and what happens to it at expiry?
  • How would rising implied volatility in the first week affect the spread's mark?

Company names and figures are illustrative.