Introduction To Long Put Ladder Option Strategy
The long put ladder, unlike the long call ladder, is constructed with put options. Hence, long put ladder and long call ladders are different option strategies. The long put ladder is an options trading strategy that involves put options at different exercise(strike) prices, but are derived from the same underlying security and have the same expiration date. As the price of the underlying security goes down, the losses can be significant on this strategy especially for an extremely overvalued underlying security.
Long put ladder – a net debit trade
When a trader executes a long put ladder, a net debit is incurred. This net debit results in a deduction from the trader’s account. A net debit is created because the options premium paid for buying puts is greater than the options premium collected from writing put options.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Anticipating Little Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Limited loss as price of underlying security increases
Step 7 : Calculate Loss
Step 8 : Limited potential for profit
Step 9 : Maximum profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade Executing a long put ladder
Step 12 : Exit Trade
Step 13 : Record Trade In Diary
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Step 1 : Perform economic, fundamental and technical analysis
An options trader must be able to predict low volatility conditions in the underlying security. To do that he needs to keep an eye on upcoming economic reports and events that will cause volatility to increase.Some suggested chart patterns to look out for are:
This is not meant to be exhaustive. Traders have a variety of technical tools or indicators which they can use at their disposal. The whole idea is to increase the odds of a maximum profit.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook : Anticipating Little Volatility
The trader that executes a long put ladder is projecting little to no volatility over the remaining life of the options. What that happens, there is an increased probability of earning a maximum profit. If there is an increased volatility in the price of the underlying security, the trader stands a chance of making a loss.
Step 3 :Study the option chain
Once the options trader is convinced of the outlook, he should examine the option chain. Here, he must choose the options to create the long put ladder.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
Breakeven price points:
The upside and downside breakeven points can be calculated by formulae. At these points, there is neither profit nor loss.
The formula for the upside breakeven point is:
S1 – net debit
S1 is the exercise(strike) price of the bought put.
The formula for the upside breakeven point is:
S2 + S3 – S1 + net debit
S2 and S3 are exercise(strike) price of the written put while S1 is the exercise(strike) price of the bought put.
S1, S2 and S3 are exercise(strike) prices of the puts where S1>S2>S3.
Step 5: Understand Your Profit Zones
After breakeven analysis, one can understand the zones where profit is made.
Step 6 : Limited loss as price of underlying security increases
A limited loss is experienced when the price of the underlying security increases. As long as the price of the underlying security trades above the upside breakeven point, a loss is realisable from the long put ladder trade.
Unlimited loss as price of underlying security decreases
When the price of the underlying security decreases, the long put ladder trade can experience an unlimited loss. The greater the magnitude of the decrease in the price of the underlying security, the greater the loss. As long as the price of the underlying security trades below the downside breakeven point, a loss is realisable.
Step 7 : Calculate Loss
Due to the way the long put ladder is constructed, the trade has an unlimited loss potential when the price of the underlying security trades to the downside. This loss can be calculated using the formula below.
Loss = Downside breakeven price point – trading price of the underlying security + commissions paid to broker
Step 8 : Limited potential for profit
Due to the way it is structured, there is only at best, a limited potential for profit. As a result, the maximum profit can be calculated with a formula.
Step 9 : Maximum profit calculation
The maximum profit can be calculated by a formula shown below:
Exercise(strike) price of bought put – Exercise(strike) price of middle strike put – net debit – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
After estimating potential profit and potential loss, the options trader should calculate the risk and reward ratio to find out the attractiveness of the trade relative to other similar trades executed in the past.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade Executing a long put ladder
A trader that executes a long put ladder will:
- Buy 1 in the money put at strike price of S1
- Write 1 at the money put at strike price of S2
- Write 1 out of the money put at strike price of S3
S1>S2>S3
For the trader to be considered a long put ladder, the ratio above must be adhered to. That is, the ratio of long in the moneys puts to short at the money puts to short out of the money puts is 1:1:1.
Step 12 : Exit Trade
If a reasonable profit has been made, the options trader should exit the long put ladder.
Step 13 : Record Trade In Diary
After the trade has been exited, the trader should record the trade in a diary, detailing profit and loss and also mistakes made along the way. Here, after examination of trade process, the trader should fine tune the trading process to experience better results in the future.
Example Of A Long Put Ladder
EEE Corp is trading at a price of $80. A trader wants to establish a long put ladder as he anticipates that price of the underlying security will experience little volatility over the short term. He establishes a long put ladder by:
- Long Dec 85 put @ $6.50
- Write Dec 80 put @ $2
- Write Dec 75 put @ $1
As a result, a net debit is incurred when the long put ladder is executed.
The net debit can be calculated as:
($6.50 – $2 – $1) x 100 = $350
When the price of EEE trades at $80 on expiration:
Beginning value | Ending value | Profit(+) or Loss(-) | |
Long Dec 85 put | $6.50 | $5 | -$1.50 |
Write Dec 80 put | $2 | $0 | +$2 |
Write Dec 75 put | $1 | $0 | +$1 |
Overall profit per share | +$1.50 |
The total profit is thus:
$1.50 x 100 = $150
This also happens to be the maximum profit that the strategy can attain. This maximum profit can also be calculated as:
(($85 – $80) – $3.50) x 100 = $150
Please refer to the maximum profit formula above.
When the price of the underlying security trades at $85 on expiration:
Beginning value | Ending value | Profit(+) or Loss(-) | |
Long Dec 85 put | $6.50 | $0 | -$6.50 |
Write Dec 80 put | $2 | $0 | +$2 |
Write Dec 75 put | $1 | $0 | +$1 |
Overall loss per share | -$3.50 |
The total loss will amount to:
$3.50 x 100 = $350
$350 is also the net debit of the long put ladder trade.
If the price of the underlying security trades at $60 on expiration of the options:
Beginning value | Ending value | Profit(+) or Loss(-) | |
Long Dec 85 put | $6.50 | $25 | +$18.50 |
Write Dec 80 put | $2 | $20 | -$18 |
Write Dec 75 put | $1 | $15 | -$14 |
Overall loss per share | -$13.50 |
In the above scenario, the total loss is:
$13.50 x 100 = $1350
The greater the price decrease of the underlying security, the greater the realisable loss. This is due to the fact that there are more short puts than long puts in a long put ladder.
Short put ladder vs Long put ladder
While the long put ladder is executed in anticipation of low volatility, the short put ladder is executed in anticipation of significant volatility in the price of the underlying security. In a high volatility environment, the short put ladder has a greater likelihood of turning a profit.