In a bear market, the lows of the first market downturn are often retested following a rally like the one we have just seen. This article examines how put options can be used to maximize the return on a bearish projection.

As can be seen in the following chart, the unit price of the iShares S&P/TSX Capped Financials Index (XFN), an exchange traded fund (ETF), has moved in a range of $24.99 to $32.75 over the past month, after peaking at $41.87 in February. Since its recent high of $32.75, the XFN ETF seems to have lost some of its bullish momentum.

 

Chart 1: Daily changes in the price of the XFN ETF to April 22, 2020 ($29.97)

Source: Tradingview.com

If our bearish scenario materializes, we can expect the $24.99 level to be tested again, perhaps by the June 2020 expiration. Taking this as our target price, we will choose among the following put options[1]:

  • XFN 200 619 P 28.25 at $1.35
  • XFN 200 619 P 29.25 at $1.65
  • XFN 200 619 P 30.25 at $2.10

 

Position

Table 1: Comparative table of put options as at April 22, 2020

Source: Montréal Exchange and Martin Noël

As the above table shows, given these three puts it is the XFN 200 619 P 29.25 put option, at $1.65 (average of the bid and ask prices), that has the optimal risk-return ratio. It will generate a potential return of 158% if the price of the XFN ETF reaches our target price of $24.99 on the June 2020 expiration. As a result, we will execute the following transaction:

  • Purchase 10 put option contracts XFN 200619 P 29.25 at $1.65
    • Debit of $1,650

 

Profit and loss profile

Source: Montréal Exchange and Martin Noël

 

Intervention

Although the target price for the XFN units is $24.99, our potential profit is tied to the $4.26 target price for the put options. So as soon as the put options reach this price we will close out the position, even though XFN ETF has not reached its target price of $24.99. Please note that no action will be taken if the price of FNB begins to rise instead of fall as we had expected. As a result, it will be important to pay close attention to the total capital invested in this strategy.

Good luck with your trading, and have a good week!

 

The strategies described in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

[1] Note that we valued all the put options expiring on June 19, 2020 but, for practical reasons, we have presented only a small sample of the options in that list.

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