Overview
Pattern evolution:
When to use: When you are bearish to very bearish on the market. In general, the more out-of-the-money (lower strike) the put option strike price, the more bearish the strategy.
Profit characteristics: Profit increases as markets fall. At expiration, break-even point will be option exercise price A – price paid for option. For each point below break-even, profit increases by additional point.
Loss characteristics: Loss limited to amount paid for option. Maximum loss realized if market ends above option exercise A.
Decay characteristics: Position is a wasting asset. As time passes, value of position erodes toward expiration value.
CATEGORY: Directional
SYNTHETICS: Short instrument, long call
Example
Scenario:
Pork Bellies have been trading at contract highs of between 75 and 85 cents per pound. The trader feels that a major decline is very likely. However, the trader is not sure when it will come. He decides to buy a long-term put option. By doing this he initially has very little time decay. He can ride out a temporary upward move and still be in for the big break.
Specifics:
Underlying Futures Contract: February Pork Bellies
Futures Price Level: 80.15
Days to Futures Expiration: 210
Days to Options Expiration: 180
Option Implied Volatility: 33.2%
Option Position: Long 1 Feb 76 Put – 5.10 ($2040)
At Expiration:
Breakeven: 70.90 (76.00 strike – 5.10 premium)
Loss Risk: Limited to the premium paid. Loss above 70.90 with maximumloss of 5.10 above 76.00.
Potential Gain: Unlimited, with profits increasing as the futures fall further and further past 70.90 breakeven.
Things to Watch:
This trader must be very bearish, with volatility increasing, to make this trade profitable. If held to expiration, the futures would have to fall more than 10% by expiration just to break even. Check the follow-up strategies if the futures fall or volatility rises to the levels expected before expiration.
