Bearish Option Strategy: Long Put And Short Call

Long Put Strategy

A long put is when a trader buys a put option as they believe the underlying asset’s price may fall. As the market keeps on falling, the value of the put option rises. However, the trader can lose if the underlying remains flat or moves higher.

Basics of a Put Option

A long put gives the buyer the right to sell the underlying stock at a desired strike price. The buyer of a put option gets the right, but not the obligation, to go short on an underlying asset at a certain price, called the strike price, on or before the expiration date. The buyer of the option pays a premium to the seller of the put contract for the right to sell the underlying stock. The buyer can close their trade by selling the option in the market or allowing it to expire worthless.

Note that the keyword here is the “right but not the obligation” to sell the underlying stock. The three important factors that the buyer of a put option needs to consider before entering the trade are:

Strike price: the predetermined price at which the underlying asset will be exchanged.
Expiration date: the date at which the contract is settled or expires worthless.
Premium paid: the price paid for buying the option.

Payoff diagram of a Long Put Option

Suppose Nifty is trading at 15,500, and a Long Put trade is taken by buying a 15500 Put for October 29, 2022 expiry. Since the market is trading at 15,500, a 15,500 Put is an at-the-money (ATM) option.

The premium paid for creating the position was Rs 120, and the value of holding the position is Rs 6,000. The maximum loss to the trader in creating the position is Rs 6,000. The trader will break even when the market crosses the strike of their option plus the cost of buying the call option.

Breakeven = 15,500 – 120 = 15,380

When to Initiate a Long Put Trade?

If a trader anticipates the underlying to be bearish, they will create a Long Put trade. This strategy is preferred by scalpers and momentum traders who are in the market for a short duration of time. Professional traders prefer taking a Long Put trade when volatility is very low.

Which Put Option to Buy?

Many retail traders make the mistake of buying a Deep out-of-the-money (OTM) Put because it is cheap. But the selection of the strike is an important factor to consider. If the trader is expecting a surprise and strong move, only then does it make sense to take a position in a Deep OTM strike, else an ATM, a slight In-the-money (ITM), or a slight OTM strike is good enough to create the position.

Factors to Consider in Selecting the Put Option Strike Price

Impact of Underlying Price Change: The relationship between the underlying and the put option is dependent on the value of the option Greek called Delta. Depending on the distance the trader expects the market to move, they can select the option strike price and pick up the one offering the best return.

Impact of Volatility: When it comes to buying options, volatility is a friend. A rise in volatility will increase the price of the option. Traders enter a Long Put trade when they see that volatility is near its lowest point in a year.

Impact of Time: Time is an enemy of the option buyer. With time, the value of the option deteriorates. Thus, a Long Put option trade can be taken when the trader expects a sharp price burst. The Long Put trade can end up in a loss even if the direction is right but has failed to cross the breakeven point by the time of expiry.

Things to Remember while Buying Put

Buying a Long Put is an indication of the investor’s bearishness. It is also an entry-level trade for hedgers.
A long put gives the buyer of the Put option the right to sell the underlying stock at the desired strike price. As the market keeps on falling, the value of Put options rises.
The alternative to buying a put option is selling a stock short. However, this strategy carries with it the possibility of unlimited risk compared to a limited loss in options.
The buyer of a Put option needs to remember three important points before entering the trade — the Strike Price, the Expiration date, and the Premium paid for buying the option

Short Call Option Strategy

What is a Short Call Option?

If a trader anticipates a decline in the price of the underlying asset, they can establish a short call position by selling a call option. As shown in the payoff diagram below, short calls offer limited profit potential and unlimited loss.

Suppose a trader sells a 17500 Call option on Nifty with a premium of 70 and a lot size of 50. Therefore, the credit received by the trader for establishing the position is Rs 3,500 (70*50).

The maximum profit potential for this trade is Rs 3,500, while the theoretical maximum loss is infinite. The margin required for establishing the trade is Rs 81,550.

The breakeven point for this trade is the strike price plus the premium collected, which is 17570 (17500+70).

When to Create A Short Call Strategy?

Discover when to create a Short Call trade and maximize your profits! A Short Call option is a popular trading strategy that allows traders to make money when the underlying asset’s price stays below the strike price sold. The best part is, even if the asset doesn’t fall, traders can still profit from Theta or time decay.

If you’re a trader who expects a downward slow move, then creating a Short Call trade is the way to go. However, for a sharp down move, buying a put option or other debit trading strategies may offer better returns. You can also use the short call strategy to take intraday trades and combine it with other options to create multi-leg strategies.

A Short Call strategy is often used in a Covered Call trade, where the short call is combined with the investor’s portfolio to create a covered call. This strategy benefits when the broad market falls or remains stagnant.

Keep in mind that the Short Call strategy has a high loss potential, so it’s better for professional traders to use it. To achieve the best results, create a Short Call trade when the Implied Volatility Percentile (IVP) or the Implied Volatility Rank (IVR) is high.

Things to Remember When Selling Call

When you sell a call option, you give the buyer the right to buy the underlying security at a specified price (the strike price) before the option contract expires. In return, you receive a premium.
With the Short Call strategy, you have more flexibility as you can set the strike price as high as you want, increasing the probability that the holder will not exercise the option.
If the buyer exercises the option, you must deliver the underlying shares to them.
The Short Call trader benefits when the option contract expires worthless, which happens if the price of the underlying security falls below the strike price.
Remember that the maximum profit for a short-call trader is defined, but their loss is unlimited.

Short Calls vs Long Puts: A Comparison

Both short call trades and long put trades benefit when the price of the underlying asset falls. However, there are significant differences between the two strategies:

Potential gains A long put options trade has the potential for unlimited gains, while the gains of a short call trader are limited to the amount of premium collected.
Potential losses If the price of the underlying asset moves higher, the loss of a long put trade is limited to the premium paid, while the short call trader has the potential for unlimited losses.
Impact of underlying asset movement If the underlying asset does not move significantly, the long put trade will experience losses, while the short call trade will benefit from price decay.

In summary, while both strategies may benefit from falling underlying asset prices, long put trades offer potentially higher gains but come with the risk of limited losses, while short call trades offer limited gains but come with the risk of potentially unlimited losses. Understanding the differences between these strategies can help traders make more informed decisions and manage their risk effectively.