Case 078Option strategies and trade ideasCore

You are bearish on a stock at Rs 250 over three months. Short the stock with an 8% borrow, buy the 250 put at 12, or buy the 250/220 put spread for 8? Show the outcomes at 200, 240 and 270.

The situation

Sonthi Polymers trades at Rs 250. Your analyst expects a weak quarter and a derating over the next three months. The stock can be borrowed through securities lending at a fee of 8% a year, so three months of borrow costs Rs 5 a share. Three-month options are quoted: the 250 put at Rs 12, and the 250/220 put spread, buying the 250 put and selling the 220 put, at a net Rs 8.

Ignore dividends and the interest on short-sale proceeds. The portfolio manager wants the three expressions compared at expiry prices of Rs 200, 240 and 270, per share.

Your task

Which expression of the bearish view would you choose, and what does each one cost you if you are wrong?

Quick check

Before working the numbers: at Rs 240, a 4% fall, which expression makes money?

Worked solution

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

30-second answerThe answer to give first

The put spread is the best fit for a three-month derating view; the outright put is the right choice only if you fear a collapse; short stock is the most expensive way to be wrong. At 200 the three earn Rs 45, 38 and 22 a share. At 240 they earn +5, -2 and +2. At 270 they lose 25, 12 and 8. The spread risks the least for a view that is about direction, not disaster.

Step 1What does each expression actually cost, before the stock moves?

A tenant can leave a flat three ways: give notice and pay rent until a replacement is found, pay a fixed break fee, or pay a smaller fee that only covers the first few months. Each trades certainty of cost against protection. Short stock has no premium but an open-ended loss and a running borrow cost; the put caps the loss at Rs 12; the spread caps it at Rs 8 by giving up gains below 220. The borrow matters more than it looks: 8% a year on a Rs 250 stock is Rs 5 over three months, and the securities lendingBorrowing shares from a long-term holder for a fee so that you can sell them and buy them back later. In India this runs through the exchange lending platform. fee can jump when the stock becomes crowded on the short side.

At stock prices of 200, 240 and 270 the short stock earns Rs 45, +5 and -25 a share, the 250 put earns +38, -2 and -12, and the put spread earns +22, +2 and -8, so the spread is cheapest to be wrong with and the short stock is the most expensive.

Step 2How do the three compare at each price?

Stock at expiry	Short stock	Long 250 put	250/220 put spread
Rs 200	+45	+38	+22
Rs 240	+5	-2	+2
Rs 270	-25	-12	-8
Worst case	unlimited	-12	-8

Profit per share in rupees after the Rs 5 borrow cost and the option premiums; the short stock wins in a crash, the spread wins on a modest fall, and the spread loses least when the stock rises instead.

Read the table across, not down. At 200 the stock is the winner because nothing was spent on protection: 45 against 38 for the put and 22 for the spread, which stops paying once the stock is below 220. At 240 the order flips: the spread is paid off at 2 while the put is still underwater. At 270 the stock loses 25 a share with no floor, the put loses its 12 and the spread its 8. The break-even prices say the same thing: 245 for the stock after borrow, 238 for the put, 242 for the spread.

Step 3Which one fits the view, and what would change your mind?

Match the structure to the shape of the view. The analyst expects a derating, a move of 5% to 15%, not a collapse. The spread pays fully across that range and refuses to pay for the crash you do not forecast, which is why it costs 8 instead of 12. Choose the outright put if the thesis is accounting trouble or a debt problem, where 150 is possible and the extra Rs 4 buys the tail. Choose short stock only if you want to pair it against a long in a peer and need a linear hedge, and then watch the borrow fee and the recall risk. The limit: options lose to time decay if the move comes late, and the stock does not, so a view with no catalyst date argues for the stock.

Where candidates lose it

The common loss is picking the put as the safest choice without noticing its cost: at 240 the view was right and the put still lost Rs 2. Protection against a crash is paid for every day the crash does not come.

The second is ignoring the borrow. Rs 5 over three months is 2% of the stock, enough to turn a small win into a loss, and the fee is not fixed.

What the interviewer asks next

How does a 2% dividend during the three months change each expression?
The borrow fee rises to 25% a year after you are short. What do you do?
Why might the put spread be priced at 8 when the 250 put is 12: what does that say about the 220 put?
How would you express the same view if you also expected volatility to rise?

Company names and figures are illustrative.