Buying Index Puts Explained

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Buying Index Puts

The index long put is the simplest strategy to use in index options trading and the implementation involves the purchase of an index put option.

Index Long Put Construction
Buy 1 ATM Index Put

The options trader employing the index long put strategy believes that the underlying index level will fall significantly below the put strike price within a certain period of time.

Unlimited Profit Potential

Since they can be no limit as to how low the index level can be at the option’s expiration date, there is no limit to the maximum profit possible when implementing the index long put strategy.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Index Settlement Value

Limited Risk

Risk for the index long put strategy is capped and is equal to the price paid for the index put option no matter how high the index is trading on expiration date.

Breakeven Point(s)

The underlier price at which break-even is achieved for the index long put position can be calculated using the following formula.

  • Breakeven Point = Index Put Strike Price – Premium Paid

Example

XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will retreat in the near future, an options trader purchases an six-month XYZ index put with a strike price of $400 expiring in December for a quoted price of $4.00 per contract. With a contract multiplier of $100, the cost of the index put option comes to $400.

Suppose XYZ Index dropped to 380 in December and the trader’s DEC 400 XYZ index put expires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option will have an intrinsic value of $20 and exercising this option will give the trader a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the cost of the option itself, which is $400, the trader’s net profit comes to $1600.

Suppose XYZ Index went up to 420 in December and the trader’s DEC 400 XYZ index put expires out-of-the-money. At settlement value of 420, the DEC 400 XYZ index put option will expire worthless with zero intrinsic value. The trader’s net loss is equal to the amount paid for the index put option which is $400.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

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However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Out-of-the-money Index Puts

Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.

In-the-money Index Puts

In-the-money puts are more expensive than out-of-the-money puts but less amount is paid for the option’s time value.

Portfolio Insurance

Index puts can also be used to protect a portfolio against a declining market without the need to liquidate any stock while at the same time enable the portfolio to participate and benefit from a rising market.

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Prices Plunging? Buy a Put!

Investors may buy put options when they are concerned that the stock market will fall. That’s because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset heads southward. Therefore, if you own a put you will benefit from a down market – either as a short speculator or as an investor hedging losses against a long position.

So, whether you own a portfolio of stocks, or you simply want to bet that the market will go down, you can benefit from buying a put option.

Key Takeaways

  • A put option gives the owner the right, but not the obligation, to sell the underlying asset at a specific price through a specific expiration date.
  • A protective put is used to hedge an existing position while a long put is used to speculate on a move lower in prices.
  • The price of a long put will vary depending on the price of the stock, the volatility of the stock, and the time left to expiration.
  • Long puts can be closed out by selling or by exercising the contract, but it rarely makes sense to exercise a contract that has time value remaining.

Prices Plunging? Buy A Put!

Speculative Long Puts vs. Protective Puts

If an investor is buying a put option to speculate on a move lower in the underlying asset, the investor is bearish and wants prices to fall. On the other hand, the protective put is used to hedge an existing stock or a portfolio. When establishing a protective put, the investor wants prices to move higher, but is buying puts as a form of insurance should stocks fall instead. If the market falls, the puts increase in value and offset losses from the portfolio.

Opening a long put position involves “buying to open” a put position. Brokers use this terminology because when buying puts, the investor is either buying to open a position or to close a (short put) position. Opening a position is self-explanatory, and closing a position simply means buying back puts that you had sold to open earlier.

Practical Considerations

Besides buying puts, another common strategy used to profit from falling share prices is to sell stock short. Short sellers borrow the shares from their broker and then sell the shares. If the price falls, the stock is bought back at the lower price and returned to the broker. The profit equals the sale price minus the purchase price.

In some cases, an investor can buy puts on stocks that cannot be found for short sales. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because the broker does not have enough shares to lend to people who would like to short them.

Importantly, not all stocks have listed options and so some stocks that are not available for shorting might not have puts either. In some cases, however, puts are useful because you can profit from the downside of a “non-shortable” stock. In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put, whereas the short seller is exposed to considerable risk as the stock moves higher.

Like all options, put options have premiums whose value will increase with greater volatility. Therefore, buying a put in a choppy or fearful market can be quite expensive – the cost of the downside protection may be higher than is worthwhile. Be sure to consider your costs and benefits before engaging in any trading strategy.

An Example: Puts at Work

Let’s consider stock ABC, which trades for $100 per share. Its one-month puts, which have a $95 strike price, trade for $3. An investor who thinks that the price of ABC shares are too high and due fall within the next month can buy the puts for $3. In such a case, the investor pays $300 ($3 option quote x 100, which is known as the multiplier and represents how many shares one option contract controls) for the put.

The breakeven point of a 95-strike long put (bought for $3) at expiration is $92 per share ($95 strike price minus the $3 premium). At that price, the stock can be bought in the market at $92 and sold through the exercise of the put at $95, for a profit of $3. The $3 covers the cost of the put and the trade is a wash.

Profits grow at prices below $92. If the stock falls to $80, for example, the profit is $15 (95 strike – $80 per share) minus the $3 premium paid for the put. The maximum loss of $3 per contract occurs at prices of $95 or higher because, at that point, the put expires worthless.

The distinction between a put and a call payoffs is important to remember. When dealing with long call options, profits are limitless because a stock can go up in value forever (in theory). However, a payoff for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95 because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0.

Close vs. Exercise

Closing out a long put position on stock involves either selling the put (sell to close) or exercising it. Let us assume that you are long the ABC puts from the previous example, and the current price on the stock is $90, so the puts now trade at $5. In this case, you can sell the puts for a profit of $200 ($500-$300).

Options on stocks can be exercised any time prior to expiration, but some contracts—like many index options—can only be exercised at expiration.

If you wished to exercise the put, you would go to the market and buy shares at $90. You would then sell (or put) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit, in this case, is also $200.

The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. This is known as the options time value. For example, if the stock is at $90 and the ABC 95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value. In this case, it is better to sell the put rather than exercise it because the additional 50 cents in time value is lost if the contract is closed through exercise..

What is index option trading and how does it work?

Index options are financial derivatives based on stock indices such as the S&P 500 or the Dow Jones Industrial Average. Index options give the investor the right to buy or sell the underlying stock index for a defined time period. Since index options are based on a large basket of stocks in the index, investors can easily diversify their portfolios by trading them. Index options are cash settled when exercised, as opposed to options on single stocks where the underlying stock is transferred when exercised.

Index options are classified as European-styled rather than American for their exercise. European-styled options may only be exercised upon expiration, while American options can be exercised at any time up until expiration. Index options are flexible derivatives and can be used for hedging a stock portfolio consisting of different individual stocks or for speculating on the future direction of the index.

Investors can use numerous strategies with index options. The easiest strategies involve buying a call or put on the index. To make a bet on the level of the index going up, an investor buys a call option outright. To make the opposite bet on the index going down, an investor buys the put option. Related strategies involve buying bull call spreads and bear put spreads. A bull call spread involves buying a call option at a lower strike price, and then selling a call option at a higher price. The bear put spread is the exact opposite. By selling an option further out of the money, an investor spends less on the option premium for the position. These strategies allow investors to realize a limited profit if the index moves up or down but risk less capital due to the sold option.

Investors may buy put options to hedge their portfolios as a form of insurance. A portfolio of individual stocks is likely highly correlated with the stock index it is part of, meaning if stock prices decline, the larger index likely declines. Instead of buying put options for each individual stock, which requires significant transaction costs and premium, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions gain value if the stock index declines. The investor still retains upside profit potential for the portfolio, although the potential profit is decreased by the premium and costs for the put options.

Another popular strategy for index options is selling covered calls. Investors may buy the underlying contract for the stock index, and then sell call options against the contracts to generate income. For an investor with a neutral or bearish view of the underlying index, selling a call option can realize profit if the index chops sideways or goes down. If the index continues up, the investor profits from owning the index but loses money on the lost premium from the sold call. This is a more advanced strategy, as the investor needs to understand the position delta between the sold option and the underlying contract to fully ascertain the amount of risk involved.

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