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A put option is the right to sell a particular stock at a specified
price for a limited period of time.
This stock is called the underlying
security.
Put
option is said to be exercised when
the stock is sold. The strike is the
price the holder of the option must
pay to exercise it.
Since
the buyer (holder) of a put has a right
to sell stock at the striking price,
the seller (writer) of a put has no
choice but to buy that stock. For assuming
the obligation to buy stock at a pre-specified
price, the writer of the put receives
the put option premium. Maximum profit
is equal to this premium if the put
expires worthless.
Each
option is valid for only a limited time;
thus, each option has an expiration
date. An option contract has four specifications:
- Type
of option (put or call)
- Name
of the underlying stock
- Expiration
date
- Striking
price
Example
1. One contract"ABC October
30 put" is an option to sell 100 shares
of the underlying ABC stock for $30
per share, the contract expiring in
July. The price of a listed option is
quoted on a per-share basis, regardless
of how many shares of stock can be bought
with the option.
If the contract in
this example is sold for 2 points, the
maximum profit is $200. The loss is
the difference between the strike price
and stock price at expiration. However,
no net loss will be realised if the
stock price goes down to 28, because
the premium of 2 points had been paid
upfront.
|
ABC
Stock Price at Expiration |
Put
Price at Expiration |
Profit |
|
24 |
6 |
-$400 |
|
23 |
5 |
-$300 |
|
26 |
4 |
-$200 |
|
27 |
3 |
-$100 |
|
28 |
2 |
0 |
|
29 |
1 |
$100 |
|
30 |
0 |
$200 |
|
31 |
0 |
$200 |
|
32 |
0 |
$200 |
A
put option is out-of-the-money if the
stock is selling above the striking
price of the option.
A put option is in-the-money
if the stock is selling below the strike.
The
intrinsic value of an in-the-money put
is the amount by which the strike exceeds
the stock price. The intrinsic value
of an out-of-the money put option
is zero. Option premium is the price
an option sells for.
Time
value is the excess of the option premium
over the intrinsic value of the option.
Time value decreases as the expiration
day approaches. Put option with a strike
close to current price of the underlying
security has the greatest time value.
Such a put, other conditions being equal,
is the most profitable put to sell.
In this respect, a put writer is a seller
of time value.
We
consider bull put option spreads, i.e.
selling a put option with a certain
strike and buying a protective put option
with a lower strike. Both options have
the same expiration date. The bull spread
is profitable if the underlying stock
goes up. As we have seen above, the
profit is limited. Fortunately, the
potential loss is also limited because
we buy a protective put. Let us modify
our previous example.
Example
2. We establish a put option
spread by buying one contract "ABC October
27 1/2 put" at 1/2 points and simultaneously
selling one contract "ABC October 30
put" at 2 points. The credit is 1 1/2
point or $150 for one contract. The
maximum profit (net credit) for this
bull spread is $150. We already
got it. Nevertheless, if the stock
moves down our loss is limited by the
difference between the strike prices
minus net credit received.
ABC
Stock Price
at
Expiration |
October
30 Put Price
at
Expiration |
Profit |
October
27 1/2 Put
at
Expiration |
Profit |
Total
Profit |
|
25 |
5 |
-$500 |
2
1/2 |
$250 |
-$100 |
|
26 |
4 |
-$400 |
1
1/2 |
$150 |
-$100 |
|
27 |
3 |
-$300 |
1/2 |
$50 |
-$100 |
|
28 |
2 |
-$200 |
0 |
0 |
-$50 |
|
29 |
1 |
-$100 |
0 |
0 |
$50 |
|
30 |
0 |
0 |
0 |
0 |
$150 |
|
31 |
0 |
0 |
0 |
0 |
$150 |
|
32 |
0 |
0 |
0 |
0 |
$150 |
Unlike in
the previous example, here we traded a
fraction of our potential profit
for a downside protection.
Profit/loss ratio is 1.5 = $150/$100.
Is it reasonable?
Is it worth taking the risk? The
answer depends on how bulish you are
on the stock. If the stock is unlikely
to go up, neither high credit nor high
profit/loss ratio will look attractive.
On the contrary, if you are very bullish
on the stock, a certain risk level appears
quite acceptable. Break-even stock price
(when we have zero profit from our investment)
is equal to the higher strike
minus net credit.
Collateral
requirement for options spread
is usually equal to $2000 for one contract.
You have to keep that much equity on
your margin account to establish a spread.
You
can enhance your portfolio, no matter
what it is! You have a unique possibility
to participate in upward stock price
movements, with a little investment.
Besides, you have a downside protection.
Just compare to outright purchase of
a stock - no downside protection and
no leverage!
It
is better to select spreads with a short
at-the-money put (strike is equal to
the current price
of the underlying
security). In this case you sell a maximum
time value. If the stock goes
substantially up, it is reasonable to
roll the spread up - to buy back the
short put at a lower price and to sell
another one at a higher price.
If
the underlying stock drops, you can
also undertake a protective action.
You can buy back your short put
at a loss and sell another one at a
lower strike. It is better to sell the
at-the-money put which contains more
time value. Remember that the price
of the protective put you bought goes
up. Therefore, rolling your spread
down you can reduce your losses even
more.
Open
our glossary and e-book to learn more!
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