A trader can use put options in a number of different ways, depending on the positions he is hedging and the options strategies he is using to hedge. A put option contract on equity stocks gives the holder (buyer) the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price up until the expiration of the put. Conversely, a trader may sell a put to collect the premium by itself or as part of a larger options strategy.
Key Takeaways
- Investors use put option strategies to reduce the risk of their investment portfolio or a specific position.
- For a long position in a stock, a trader may hedge with a vertical put spread, which provides a window of protection to the downside.
- The put spread provides protection between a higher strike price and a lower strike price.
- If the price goes below the lower strike price, the spread does not provide any additional protection.
Understanding Hedging With Short Put Options
Investors use hedging strategies to reduce the risk of their investment portfolio or a specific position. A hedge essentially protects from an adverse movement in price against the underlying position, stock, or portfolio. The goal of a hedge is to reduce risk and limit or eliminate the potential for loss.
Although options strategies are often used by investors to earn a profit and generate income, they are also frequently used to help protect an investment position, such as the ownership of a stock.
Purchased Put Option
A purchased put option (long) allows an investor the right, but not the obligation, to sell a security at the option's preset strike price before or at expiration. For example, let's say an investor bought a stock at $100 and wanted protection to limit any losses.
The investor decided to buy a put option with a strike of $90, in which the option will earn a profit when the stock falls below $90. However, the investor paid a premium for the option, and this up-front fee cost $2, meaning the put option wouldn't earn money until the stock fell below $88 per share. In other words, beyond $88, the put option would earn money to offset any losses in the stock position.
Stock Price Was at $85 at Expiry
If the stock went to $85, the investor could sell the 100 shares of the stock at $85 in the market and lose $15 ($100 - $85). However, the investor would exercise the put option and earn the difference between the $90 strike price and the $85 market price. When factoring in the $2 premium, the option trade would earn a $3 profit ($90 strike - $85 market price - $2 premium).
The $3 profit from the put would partially offset the $15 loss on the long position in the stock and would limit the loss to $12 per share.
Stock Price Was at $110 at Expiry
If the stock was $110 at expiry, the option wouldn't be exercised and would expire worthless. The reason it expires worthless is that the investor wouldn't exercise the option to sell the shares at the strike of $90 when the stock can be sold at $110 per share in the market. However, the investor would lose the $2 premium, which is the maximum amount of loss on the option trade. Assuming the investor sold the position at $110, the profit would be $8 or ($110 - $100 purchase price - $2 premium).
Sold Put Option
Rather than exercise the right to sell the stock at $90, the investor could sell the put option to someone else to close out the position. The investor would then collect a premium, which would offset the premium they paid to open the original position. Since they would be giving up the right to exercise the option, they could either sell the stock in the open market or decide to keep it in hopes that it will rebound.
For the option seller that is opening a position, it means that someone else has the right to exercise the option against the seller and "put" their long position onto the option seller at the strike price. In other words, while the option seller will collect a premium upfront, they can be forced to buy the shares at the strike price, if and when, the option is exercised. Using the earlier example, let's say the investor sold the $90 strike put and received $2 in premium for the sale. Where the stock closes at expiry will determine if there is a profit or loss on the transaction.
Stock Price Was at $85 at Expiry
If the stock price was at $85, it would be exercised, and the investor would have to buy the shares at the $90 strike price. In other words, the put option buyer, who presumably had a long position where they bought the shares at $100, would want to sell their shares at the $90 strike (capping their losses) since the price was at $85 in the market. The put option buyer forces the put option seller to buy the shares at $90 per share.
Assuming the investor immediately unwound the shares after the put option was exercised, the loss would be $5 ($90 strike – $85 market price). The $2 premium paid to the option seller up front would help to mitigate the loss, reducing it to $3 ($5 loss – $2 premium earned).
Stock Price Was at $110 at Expiry
If the stock was $110 at expiry, the option wouldn't be exercised and would expire worthless. The reason it expires worthless is that no investor would exercise the option to sell their shares at the strike of $90 when they can sell them in the open market at $110 per share. However, the option seller would pocket the $2 premium, which is the maximum amount that could be earned on the trade.
Worst-Case Scenario
The worst-case scenario for an option seller is that they're exercised and forced to buy the stock, and the stock price goes to zero. Using the earlier example, the investor who sold the put at the $90 strike would lose $90, but with the $2 premium received, the net loss would be $88. Since one option equals 100 shares of stock, the investor would have lost $8,800.
Vertical Put Spread
Option strategies called spreads help to mitigate the risk of loss for option sellers by capping the losses on the trade. For a long position in a stock or other asset, a trader may hedge with a vertical put spread. This strategy involves buying a put option with a higher strike price,then selling a put with a lower strike price. However, both options have the same expiry. A put spread provides protection between the strike prices of the bought and sold puts. If the price goes below the strike price of sold puts, the spread does not provide any additional protection. This strategy provides a window of protection to the downside.
Let's say an investor bought a stock at $92 and wanted downside protection. However, a $90 strike put option costs $4 to purchase, which is too costly to the investor. The investor decides to sell a lower-strike put to offset the cost. Below is how the option strategy would look:
- Put option with a strike of $90 (purchased option) at a premium of $4
- Put option with a strike of $75 (sold option) and receives a $3 premium
- Net cost of $1 in premium
The investor is protected if the stock price declines below $90 and remains above $75. However, if the stock falls below $75, the option strategy no longer provides protection.
A vertical put spread strategy has advantages and disadvantages over just a bought put. Typically an outright put option is quite costly for many investors. However, buying a put option provides the maximum protection for those who are long the underlying stock. Even if the stock price goes zero, the stand-alone put option protects the investor below the strike price.
The vertical spread, on the other hand, protects the investor up to the strike of the sold put option or the lower-priced strike. Since the protection is capped, it's less costly than a stand-alone put.
Benefits of Selling Put Options as Hedges
Put options provide downside protection for a long position. Even though the protection offered from the vertical spread is capped, it can be quite helpful if the stock is expected to have limited downside moves. For example, a well-established company's stock price might not fluctuate too wildly, and a put spread could protect an investor within a range.
It's important that investors become familiar with the various types of options before entering into a trade. Many brokers require investors to complete and pass an online training class before an investor can execute hedging strategies with options.
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