InvestorQ : Is it also possible to use covered put when we are moderately bearish on the dollar and expect it to moderately weaken vis a vis the rupee? What would be the payoffs in this case?
Ria Jain made post

Is it also possible to use covered put when we are moderately bearish on the dollar and expect it to moderately weaken vis a vis the rupee? What would be the payoffs in this case?

Answer
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1 year ago


A covered put is normally used when you have sold a stock or an index and then the price has gone up. Therefore you want to increase your average cost of selling the futures without endangering your profitability. How does a covered put work? You sell the futures on the USD-INR because you expect the dollar to weaken. You will use the covered put when you expect the dollar to weaken marginally. Let us see the table below how it works.

Sell Futures

73.00

Prem

N.A

Strategy

Covered Put or Average Short Cost Reducer

Sell OTM Put

72 Strike

Prem

0.30

Sell 73 futures and Sell 72 put

Break Even

Cost is reduced by premium received

Price

Sell Futures

Put Strike

Put Premium

Break Even Cost

ITM / OTM

P/L on Futures

P/L On Put

Overall P/L

68.00

73.00

72.00

0.30

73.30

ITM

5.00

-3.70

1.30

68.50

73.00

72.00

0.30

73.30

ITM

4.50

-3.20

1.30

69.00

73.00

72.00

0.30

73.30

ITM

4.00

-2.70

1.30

69.50

73.00

72.00

0.30

73.30

ITM

3.50

-2.20

1.30

70.00

73.00

72.00

0.30

73.30

ITM

3.00

-1.70

1.30

70.50

73.00

72.00

0.30

73.30

ITM

2.50

-1.20

1.30

71.00

73.00

72.00

0.30

73.30

ITM

2.00

-0.70

1.30

71.50

73.00

72.00

0.30

73.30

ITM

1.50

-0.20

1.30

72.00

73.00

72.00

0.30

73.30

ATM

1.00

0.30

1.30

72.50

73.00

72.00

0.30

73.30

OTM

0.50

0.30

0.80

73.00

73.00

72.00

0.30

73.30

OTM

-

0.30

0.30

73.50

73.00

72.00

0.30

73.30

OTM

-0.50

0.30

-0.20

74.00

73.00

72.00

0.30

73.30

OTM

-1.00

0.30

-0.70

74.50

73.00

72.00

0.30

73.30

OTM

-1.50

0.30

-1.20

75.00

73.00

72.00

0.30

73.30

OTM

-2.00

0.30

-1.70

75.50

73.00

72.00

0.30

73.30

OTM

-2.50

0.30

-2.20

76.00

73.00

72.00

0.30

73.30

OTM

-3.00

0.30

-2.70

76.50

73.00

72.00

0.30

73.30

OTM

-3.50

0.30

-3.20

77.00

73.00

72.00

0.30

73.30

OTM

-4.00

0.30

-3.70

In the above case of covered put the trader is moderately bearish on the weakening of the dollar or rather the strengthening of the rupee. Hence they have sold USD-INR futures at Rs.73 and sold a 72 strike put at Rs.0.30. The break even cost for the covered call will be Rs.73.30 because your cost of the short futures gets increased to that extent by the amount of premium. Above this level of 73.30 your losses are unlimited so this strategy should not be used when there is upside risk in the currency strengthening. On the upside, your profits will get limited at the point at which your put option is sold (which is 72 in this case). You will find that below this level your profit is static at Rs.1.30. In the above case, the trader has a maximum profit of Rs.1.30 which consists of Rs.1 as gap between the strike of put and futures and Rs.0.30 received as premium on the put . Here are a few key inferences that you can draw from this above table.

· The breakeven point is arrived at by adding the premium of the put option to the cost of the futures sold short. Above this point we can have unlimited losses above the level of 73.30. The upside risk is open in this case and hence you need to be cautious.

· This strategy is a good strategy to help you make money on the moderate weakening of the dollar or the moderate strengthening of the rupee. However, at the same time your risk of dollar strengthening above 73.30 is an open risk for you.

The question is what would have happened had we sold a 71 strike put option (premium of 0.05) instead of a 72 strike call option. What will be the trade off in this case? Let us check it out.

Sell Futures

73.00

Prem

N.A

Strategy

Covered Put or Average Short Cost Reducer

Sell OTM Put

71 Strike

Prem

0.05

Sell 73 futures and Sell 71 put

Break Even

Cost is reduced by premium received

Price

Sell Futures

Put Strike

Put Premium

Break Even Cost

ITM / OTM

P/L on Futures

P/L On Put

Overall P/L

68.00

73.00

71.00

0.05

73.05

ITM

5.00

-2.95

2.05

68.50

73.00

71.00

0.05

73.05

ITM

4.50

-2.45

2.05

69.00

73.00

71.00

0.05

73.05

ITM

4.00

-1.95

2.05

69.50

73.00

71.00

0.05

73.05

ITM

3.50

-1.45

2.05

70.00

73.00

71.00

0.05

73.05

ITM

3.00

-0.95

2.05

70.50

73.00

71.00

0.05

73.05

ITM

2.50

-0.45

2.05

71.00

73.00

71.00

0.05

73.05

ATM

2.00

0.05

2.05

71.50

73.00

71.00

0.05

73.05

OTM

1.50

0.05

1.55

72.00

73.00

71.00

0.05

73.05

OTM

1.00

0.05

1.05

72.50

73.00

71.00

0.05

73.05

OTM

0.50

0.05

0.55

73.00

73.00

71.00

0.05

73.05

OTM

-

0.05

0.05

73.50

73.00

71.00

0.05

73.05

OTM

-0.50

0.05

-0.45

74.00

73.00

71.00

0.05

73.05

OTM

-1.00

0.05

-0.95

74.50

73.00

71.00

0.05

73.05

OTM

-1.50

0.05

-1.45

75.00

73.00

71.00

0.05

73.05

OTM

-2.00

0.05

-1.95

75.50

73.00

71.00

0.05

73.05

OTM

-2.50

0.05

-2.45

76.00

73.00

71.00

0.05

73.05

OTM

-3.00

0.05

-2.95

76.50

73.00

71.00

0.05

73.05

OTM

-3.50

0.05

-3.45

77.00

73.00

71.00

0.05

73.05

OTM

-4.00

0.05

-3.95

In the above case of covered call the investor is above moderately bearish on the weakening of the dollar. Hence they have sold USD-INR futures at Rs.73 and sold a 71 strike put at Rs.0.05. The break even cost for the covered put will be Rs.73.05 because your cost of the short futures gets increased to that extent by the amount of premium earned. Above this level of 73.05 your losses are unlimited so this strategy should not be used when there is upside risk in the dollar currency. On the downside, your profits will get limited at the point at which your put option is sold. In the above case, the trader has a maximum profit of Rs.2.05 which consists of Rs.2 as gap (73 – 71) between the strike of put and futures and Rs.0.05 received as premium on the put sold. Here are a few key inferences that you can draw from this above table.

· The breakeven point is arrived at by adding the premium of the put option to the cost of the futures sold. Above this point we can unlimited losses above the level of 73.05. The upside is open in this case and hence you need to be cautious when the dollar is strengthening and avoid using this strategy.

· This strategy is a good strategy to help you make money on the moderate weakening of the dollar or the strengthening of the rupee. However, at the same time your risk of dollar strengthening above 73.05 is an open risk for you.

· How does it differ from the previous case where 72 put was sold. You are able to take your profit range higher by selling 71 put options but you also reduce your breakeven on the upside and thus it becomes more risky.

Practically, when do you use this strategy? For example, if you expected the dollar to weaken and sold USD-INR futures and if the dollar actually strengthened instead then you can keep selling lower strike put options that will expire out of the money so that the premium earned by you can increase the cost of the short futures position in your case.