Page 89 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 2. Long Put: A long put is simply the purchase of one put option. Like the long call, a long
put is a nice simple way to take a position on market direction without risking everything.
Except with a put option we want the market to decrease in value. Buying put options is
a fantastic way to profit from a down turning market without shorting stock. Even though
both methods will make money if the market sells off, buying put options can do this with
limited risk.
When you are very bearish, buy a put option. When you are very bearish on the market as
a whole, buy put option on indices (Nifty/Sensex). When you are very bearish on a
particular stock, buy put option on that stock. The more bearish you are, the more out of
the money (lower strike price) should be the option you buy. No other position gives you
as much leveraged advantage in a falling market with limited downside. The pay-off for
long put is depicted in Figure 7.9.
Upside potential: the price of the option increases as the price of the underlying price
falls. You can square up your position by selling the same option at a higher price
whenever you think that the underlying price has come to the level you expected. At
expiration the break-even underlying price is the strike price minus premium paid for
buying the option.
Downside risk: Your loss is limited to the premium you have paid. The maximum you can
lose is the premium, if the underlying price is above the strike price at expiry of the
option.

Maximum Loss: Limited to the net premium paid for the option.
Maximum Gain: Unlimited as the market sells off.
When to use: When we are bearish on market direction and bullish on market
volatility.

Figure 7.9: Profit/Loss at Expiration for Long Put

Example: Let us consider TISCO currently trading at ` 540. An investor
believes a future bearish trend in stock market, and thus is interested in a Long Put strategy
for hedging. The investor can buy a TISCO 1-month 540 put for ` 12. Let us illustrate the
pay-off profile of Long put for the following stock prices: ` 495, 505, 515, 525, 535, 540, 550, 570,
575 and 590.

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