Mastering Derivatives: How to use puts to buy the underlying

Venkatesh Bangaruswamy | Updated on: Mar 05, 2022

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Options are useful for capturing short-term price movements in the underlying. Sometimes, you can short options to take exposure to a preferred underlying. This week, we discuss when to use short puts to buy an underlying.

Limit price?

Suppose you want to buy shares of Hindalco at a limit price of ₹550. You believe that the stock has shown a decisive breakout, but you are unsure if you will be able to buy it at ₹550, given that it currently trades at ₹570. You could purchase the stock using options.

You should short a near-month put instead of buying a call. Why? For one, a short put obligates you to buy the underlying. The obligation aligns with your objective of wanting to buy the underlying. For another, buying a call is an additional cost. Your objective here is to reduce the cost of buying the underlying. You receive premium when you short options. That can reduce the cost of purchasing the underlying. Suppose you short the March 570 put on Hindalco for 21 points. You can collect a premium of ₹22,575 (permitted lot size is 1075) for one contract. What happens if Hindalco declines below ₹570 at contract expiry?

You are obligated to buy 1075 shares of Hindalco at ₹570 per share for a total of ₹6.13 lakh. Your total cost would be, however, only ₹5.90 lakh because you collected ₹22,575 as premium for the short put. So, the per share cost is ₹549, close to your limit price of ₹550. Of course, using short puts to purchase an underlying forces you to buy pre-defined number of shares of the underlying.

What happens if the stock trades above ₹570? The March 570 put will expire worthless and the 21-point premium you collected will be your profit. You missed the opportunity to buy the stock, but you profited from the short put position.

The principle of choosing a strike for this trade is not based on the implied volatility rule. This is because your primary objective is not to profit from the option position, but to buy the underlying. Therefore, you should simply select a strike such that the strike price less the premium is equal to or close to your preferred limit price. With Hindalco, given the preferred limit price of ₹550, we chose the ₹570 strike that had 21-point premium.

You can close your short position any time before contract expiry and use the gains from the short put to reduce the cost of buying the stock. Suppose the stock trades at ₹590 a week after you short the put. The March 570 put could be worth 11 points giving you gains of ₹10,750 (21 less 11) per contract. Now, suppose you buy 100 shares of Hindalco at ₹590. Your actual cost will be ₹482.50 (59,000 less 10,750). This is an optimal strategy if you want to buy fewer shares and do not mind paying a higher price (compared to your preferred limit price) to buy the underlying.

Optional reading

How about choosing a strike that matches with your limit price? You can collect a premium of 13 points if you short the March 550. But you will be obligated to buy the shares only if the stock declines below 550 at contract expiry. At that time, your total cost will be ₹537 per share, not your preferred limit order of ₹550.

Buying at a lower price is not necessarily good. Why? You missed the opportunity to buy the stock at the break-out level of ₹550. Your intention is to buy the stock close to its breakout level; a decline below this level could well mean that the stock may be losing its momentum. Of course, this does not mean that you will not be exposed to downside risk after you buy the shares using short puts.

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

Published on March 05, 2022
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