Derivatives

How to set up conversion spreads for puts

Venkatesh Bangaruswamy | Updated on May 09, 2021

Evaluate all options before you convert original position to a spread

Previously, we discussed how to salvage a loss-making long call position by converting it to a bull call spread and how to convert a loss-making call spread to a ratio spread. This week, we combine these two strategies and apply them to puts.

Spread conversion

Suppose you have a view that an underlying will decline 100 points from the current level of 14567. You buy the 14500 for 70 points. Note that your choice of a strike should depend on the “implied volatility” rule applied to the at-the-money, the immediate in-the-money and immediate out-of-the-money strikes. We discussed the rule in this column dated December 13, 2020.

What if the underlying climbs to 14610 two days after you buy the put? The put would decline to 44 points. Now, what if you have a view that the underlying is likely to decline subsequently from current level to , say, 14530? You can convert long put to a bear put spread.

The strategy can be set up as follows: First, buy one contract of the closest strike to the underlying- the 14600 put for 82 points. Next, sell two contracts of 14500 puts for a total of 88 points. This would close one contract of your existing long position on the 14500 put and create one short position on the same strike. You now have a bear put spread- long 14600 put, short 14500 put.

The maximum profit on the conversion spread will be the difference between the strikes plus conversion credit less cost of the long put- 36 points (100 plus 6 less 70). The breakeven for the position will be the higher strike plus conversion credit less cost of the long put- 14536, which is better than the breakeven for the initial long put- 14430.

But what if your initial position was a 14500/14400 bear put spread? You would have set up the spread for 28 points when the underlying was at 14567 (70 less 42 points). If the underlying climbs to 14610 thereafter, this spread would lose 6 points (44 less 22 points). Importantly, you would have revised your earlier view on the underlying.

Suppose you now believe that the underlying will not decline below 14500. You can convert your bear put spread into a ratio spread. The strategy can be setup as follows: First, buy one contract of the 14600 put for 82 points. Next, sell two contracts of the 14500 put for 88 points. You are now long 14600 put, short 14500 put and short 14400 put. Your maximum profit will the difference between the first two strikes plus conversion credit less net debit of the put spread. That would amount to 78 points and occurs if the underlying trades between 14500 and 14400 at option expiry.

Optional reading

The objective of converting your long put to a bear put spread or a bear put spread to a ratio spread is to improve the breakeven for the position and recover losses, if not make profits. That is why the conversion should be set up for a credit.

It is also important that you consider alternatives before you convert your original position to a spread. For both long put and a bear put spread, this would be evaluating whether it would be better to close the initial position and simply take losses, now that the view on the underlying has changed.

In the case of a bear put spread, you also have the choice of converting the position to a higher strike spread. That is, from a 14500/14400 spread, you can move to a 14600/14500 spread. This means you have to buy the 14400 put to cover your short position. The additional cost of the put (16 points) will lower your maximum profit to 62 points and your breakeven to 14562 as against 14578 for the ratio spread.

The author offers training programmes for individuals to manage their personal investments

Published on May 09, 2021

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