Short Put Ladder : Profit From Increased Volatility

Introduction To Short Put Ladder Option Strategy

Short put ladder

The short put ladder is named as such because its payoff diagram resembles a ladder and it is constructed with puts. In essence, the short put ladder is an option trading strategy that uses put options to establish a trade that will capitalise on the increased volatility of the price of the underlying security. It is also known as a strategy with unlimited profit potential and limited loss potential. The put options which are used to create the short put ladder are derived from the same underlying security, have the same expiration date but different exercise(strike) prices. The exercise(strike) prices are of 3 different values and they consists of a highest strike price, a middle strike price and a lowest strike price.

Short put ladder – a net credit trade

When a trader executes a short put ladder, a net credit is received by the trader. This occurs because the total options premium collected from writing puts is greater than the total options premium paid from buying puts.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipate Increase In Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Loss calculation For A Short Put Ladder
Step 8 : Profit
Step 9 : Profit calculation For Short Put Ladder
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a short put ladder
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

This step is vital to in order to find out what the forecast for a security looks like. Some suggested chart patterns to look out for are:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Anticipate Increase In Volatility

The options trader who executes a short put ladder is anticipating a spike in volatility of the underlying security in the near term. These spikes in volatility are increased levels of measurable price movements of the underlying security. Preferably, the price of the underlying security should decrease.When that happens, the trader stands a chance of earning an unlimited profit. This is of course the best scenario. If the price of the underlying security increases, the profit potential tends towards a limited one. This is the 2nd preferred scenario. Refer to the payoff diagram of the short put ladder.

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Step 3 :Study the option chain

Study the options chain and select the options to be used in the creation of the short put ladder.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

There is a lower breakeven point and an upper breakeven point for the short put ladder. The breakeven points exist to tell the trader that there is no profit or loss to be realised when the trade is exited at these price points.

The lower breakeven point and the upper breakeven point can be calculated using formula. The formula for calculating the lower breakeven point is:

Sum of the strike price of the long puts – strike price of the written put – net credit

The formula for calculating the upper breakeven point is:

Strike price of written put – net credit

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Step 5: Understand Your Profit Zones

Short put ladder

After the breakeven points are calculated, the options trader is able to understand where the profit zones are. The profit zones are outside of the breakeven points.

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Step 6 : Limited loss

The loss potential of a short put ladder is limited. This means that the loss cannot increase beyond a certain level. That loss is essentially capped.

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Step 7 : Loss calculation For A Short Put Ladder

The maximum loss of a short put ladder can be calculated with a formula. This formula is:

Strike price of written put – Strike price of the at the money long put – net credit + commissions paid to the broker

Recall the above example where short put ladders are constructed with varying strike prices where:

S3>S2>S1

Hence, the maximum loss can be calculated as :

S3 – S2 – net credit + commissions

Since there are long puts at 2 different exercise(strike) prices, the strike price of the at the money long put refers to the long put with the higher strike price. It is also the put with the middle strike price when all puts are considered.

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Step 8 : Profit

Unlimited profit when the price of the underlying security decreases

If the price of the underlying security trades below the lower breakeven point, a profit is realisable. The further below the lower breakeven point the price of the underlying security is, the greater the realisable profit. Hence, there is unlimited profit potential as the price decreases. But, the price must move below the lower breakeven point.

Limited profit when the price of the underlying security increases

As the price of the underlying security increases above the upper breakeven point, a profit is realisable. As the price of the underlying security increases beyond the upper breakeven point, so does the realisable profit. However, at some price point above the breakeven point, the profit stays constant.This constant profit is shown as a horizontal line on the payoff diagram. This maximum profit is also the net credit received.  Please refer to the payoff diagram of the short put ladder.

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Step 9 : Profit calculation For Short Put Ladder

The profit of the short put ladder can be calculated with the help of formulae.

If S1, S2 and S3 are the exercise(strike) prices of the put options where:

  • 1 written in the money put at strike price of S3
  • 1 long at the money put at strike price of S2
  • 1 long out of the money put at strike price of S1

Note that :  S3>S2>S1 (S3 is the highest strike price)

Then a profit is realisable when S2 + S1 – S3 – net credit is greater than the price of the underlying security. It could also be said that when the price of the underlying security is greater than resultant value of S2 + S1 – S3 – net credit, a profit is realisable.

Another way to express the condition for profit is:

Price of the underlying security < Sum of strike price of long puts – Strike price of written put – Net credit

The above sections covers the condition under which profitability is achieved. Let us examine the profit formula. The profit can be calculated as:

Lower breakeven price point – price of the underlying security

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Step 10 : Calculate Risk & Reward Ratio

After the steps above have been performed, the options trader should calculate the risk and reward ratio, comparing the attractiveness of this trade relative to others.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a short put ladder

The short put ladder consist of put options of varying strike prices of S3, S2 and S1.

S3>S2>S1

A short put ladder consists of:

  • 1 written put at strike price of S3
  • 1 long put at strike price of S2
  • 1 long put at strike price of S1

The ratio above is to be adhered to for the trade to be considered a short put ladder.

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Step 12 : Exit Trade & Record Trade In Diary

After the trade is exited, the trade’s performance should be recorded in a diary or a journal. The  trader should conduct a personal reflection on the trade and find ways to improve his personal trading algorithm.

Example Of A Short Put Ladder

DDD Corp trades at $70 currently with 45 days to the expiration of the December options. The trader executes a short put ladder by:

  • Short Dec 75 put @ $6.50
  • Long Dec 70 put @ $2.50
  • Long Dec 65 put @ $1.50

The net credit received is :

($6.50 – $2.50 – $1.50) x 100 = $250

When the price of the DDD Corp trades at $70 on expiration of the options:

Beginning value Ending Value Profit(+) or Loss(-)
Short Dec 75 put $6.50 $5 +$1.50
Long Dec 70 put $2.50 $0 -$2.50
Long Dec 65 put $1.50 $0 -$1.50
Overall loss per share $2.50

The total loss when DDD trades at $70 is :

$2.50 x 100 = $250

This is the maximum loss of the short put ladder in this example. When the price stagnates and stays constant, the trader will earn a maximum but capped loss.

If the price of DDD Corp trades at $75 on expiration of the options:

Beginning value Ending Value Profit(+) or Loss(-)
Short Dec 75 put $6.50 $0 +$6.50
Long Dec 70 put $2.50 $0 -$2.50
Long Dec 65 put $1.50 $0 -$1.50
Overall profit per share +$2.50

From the table above, the total profit can be calculated as:

$2.50 x 100 = $250

This is also equal to the net credit received initially.

When the price of DDD trades at $50 on expiration:

Beginning value Ending Value Profit(+) or Loss(-)
Short Dec 75 put $6.50 $25 -$18.50
Long Dec 70 put $2.50 $20 +$17.50
Long Dec 65 put $1.50 $15 +$13.50
Overall profit per share +$12.50

The total profit when the price of the underlying security is at $50 is thus:

$12.50 x 100 = $1250

As you can see, the total profit received in this case is greater than the total net credit received when the price of the underlying security trades at $75. This is because there is an unlimited profit potential as the price of DDD decreases. Also, do note that there are more long puts than short puts in a short put ladder. Hence, the significant decrease in underlying security price will be accompanied by a significant profit. This is consistent with the payoff diagram of a short put ladder.

Short put ladder vs Long put ladder

A short put ladder and a long put ladder have different projections on the price of the underlying security. A short put ladder is executed with an anticipation towards increased volatility while a long put ladder is executed with an anticipation towards little volatility.

Read : Execute A Long put ladder : Profit from low volatility conditions

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