The Hindu Business Line : Derivative strategies: Using puts for discount buys

Traders typically place limit orders to buy stocks at a discount. But this is not always possible. This article discusses two alternative strategies that will enable traders to buy stocks at a discount. Both strategies involve setting up trades in derivatives.

B. Venkatesh

Traders extensively use limit-orders to buy a stock at a discount to the market price. The present market structure does not allow traders to use Good Till Cancelled (GTC) order to buy or sell a stock at a certain price. Everyday, a trader has to place a limit order till the request is filled. At times, this becomes an arduous task. Fortunately, limit-orders are not the only alternative available to traders seeking to buy stocks at a discount.

This article discusses two derivatives strategies that help traders reduce their cost of buying a stock. The first involves using puts and the second, ratio put-spread. Traders can choose a strategy depending on their near-term view on the underlying.

Trade set-up

Suppose the trader wants to buy Reliance Industries whose current market price is Rs 2,235. Assume the trader is of a view that the stock will not decline below Rs 2,125 before the expiry of the August contracts. She wants to buy 75 shares of Reliance for her core portfolio, which is equivalent to one option contract.

Puts as alternatives

The trader can decide to short the August 2160 puts at 20 points premium. If the puts expire worthless, the trader can use this premium to acquire the stock at a discount to the market price.

Selling puts does not come without risks. What if the underlying declines to Rs 2,150 just two days thereafter? The August 2160 puts could jump to 35 points, causing a 15-point loss.

What if the trader had sold the August 2200 puts instead? The Indian options market follows a cash-settled design. This means that the put seller does not have to buy the underlying if the buyer exercises her right under the contract. The transaction is cash-settled.

The trader can, hence, change her mind about acquiring the stock because of its near-term weakness. She will then incur a loss of 15 points against 85 points if she had bought the underlying at Rs 2,235.

If the put seller decides to buy the stock, her cost would be Rs 2,165- stock price of Rs 2,150 and loss of 15 points on the puts. If the stock instead moves up to Rs 2,250 in two days, the put option could drop to 9 points. The trader can cover the puts at 11-point profits but will have to buy the stock at Rs 2,250. The effective cost would be Rs 2,239.

Short puts can be effective when the trader expects the stock to move up marginally or trade sideways in the near- term. But what if the trader strives to profit from the near-term decline in the underlying price?

Ratio put spreads

Suppose the trader decides to buy one contract of August 2220 puts, sell one contract of August 2190 puts and sell one contract of August 2100 puts. The ratio spread can be set-up at no cost without including brokerage commissions. This is because the long-leg will be subsidised by the two short-legs.

If the underlying declines to Rs 2,150 in two days after the trade set-up, the spread could generate five points profit not adjusting for trading costs. The trader can now buy the stock at Rs 2,150.

The ratio put spread will generate maximum profits if the underlying expires at Rs 2,190. The August 2220 will then carry 30 points while the short options will expire worthless. The trader can use the 30 points profits to subsidise the cost of the stock. The underlying can be acquired for a total cost of Rs 2,160, which is Rs 2,190 less 30 points profit.

It is preferable to set-up the long-leg with at-the-money puts or near at-the-money puts. A ratio put spread is more suitable than short puts if the stock is expected to decline marginally in the near term. Besides, the risk is lower than short puts.

But why set-up short puts or long ratio put spreads when a trader can simply execute a limit order?

Conclusion

Only a small proportion of traders buy stocks at the market price. Most place a limit order to buy a stock at a lower price. Using limit-order has its problems. Sometimes, a stock may climb up without filling the limit-order. In such cases, the trader has to revise her order and buy at a higher price. At other times, the stock may go down in value after the trader purchases it.

Short puts enable a trader to reduce the cost if the stock trades in a range or moves up marginally. Long ratio put spread subsidises the cost significantly if the stock moves down. Both these strategies are alternatives to buying a stock using limit order. A trader should decide on the optimal strategy based on how she expects the underlying to move in the near-term.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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