Mechanics of put options
Put options are designed to give you exposure to bearish price movement in an asset. As is the case with calls, your risk with puts is limited to the size of the option premium you pay. This would happen if the asset price is above the exercise price at option expiry.
You gain leveraged exposure to falling prices, while also locking in a sell price, whether you own the underlying asset and wish to protect it, or not. The more the asset’s price reduces, the more profit you can make. Once the asset price is below the exercise price, the option gains intrinsic value. With this type of option, your breakeven point is the exercise price less the option premium.
Put options instead of other instruments
While shorting has become more accepted in recent years, there are restrictions on the assets you can short, the methods with which you do so, and also an unlimited level of risk. Puts however, provide limited risk while still gaining leverage:
Limited risk - the monetary downside on a worthless option may be less than the potential losses if directly exposed to a price increase in the underlying asset while shorting it
Leverage - you can increase your exposure because the option premium is denominated to a smaller scale than the asset, thus magnifying its movement in percentage terms, down and up
Consider: 1000 shares ABC @$5 each vs 1 ABC July $5 put option contract @ $0.25 (1000 shares)
Although puts can benefit the holder, the risks revolve around neutral or positive movements in the underlying asset price. Like calls, timing is a risk due to time decay, whereby there is only intrinsic value at the option’s expiry. The decrease in the asset price must compensate for lost time value. If the asset is above the exercise price at expiry, the option becomes worthless. A decline in implied volatility can also work against the option premium.
Choosing between put options
When you buy a put, you can choose the exercise price and expiry date. This is best done while considering the option premium and subsequent breakeven point.
More often than not, puts with the highest exercise price also have the highest premium and hence, the highest breakeven point. You will require a smaller fall in the asset price to begin making profits, but there is a larger amount to lose if the price increases.
The lower the exercise price, the more likely it is the option premium will be lowest too, since further price falls are required to reach there. While significant gains can be made if the asset price decreases, it may require a large and potentially unlikely movement.
If you choose a put with an exercise price around the current market price, it is probable the option premium will lie between the two extremities. In the same way as its call equivalent, this option carries the most time value and exposure to losses if the asset price is flat. To summarise:
Option expiry is another factor when buying a put. Puts with a longer expiry are initially less exposed to time decay, which enhances its time value and premium. This creates more risk due to the higher value at stake, while also requiring further price falls to reach the lower breakeven point on the chart.
For calculating profits at expiry, you must measure the intrinsic value of the option (there is no time value remaining), less the option premium. Remember, with a put, the intrinsic value is the amount by which the asset price is below the option’s exercise price.
Closing out a put option
At expiry, if the asset price is above the exercise price, the put expires worthless. Assuming the asset price is lower, at expiry, or beforehand, the option is in the money.
Where a put differs from a call, is if you already own the underlying asset which you hold the put over.
● If you own the asset, you will need to consider whether you want to sell the underlying asset
if yes, you exercise the put you bought
If not, you decide if you want to hold the put by rolling it over to another put, or selling it
● If you do not own the asset, you must consider whether you want to continue holding the put before it expires worthless
If yes, you can roll it over to another put
If not, you can sell the put
Put options may be sold, exercised or rolled over before expiry.
Selling before expiry is usually done to lock in profits from a falling asset price, since intrinsic value has risen. Also, there is still time value. If the option is out of the money, you may still choose to sell the put to mitigate your losses and recoup some proceeds via the option’s time value.
Exercising the put would only be done if you hold the underlying asset since you would be required to deliver the underlying asset as part of the settlement.
Rolling your position closes your put but opens a new one at the same time. This is done prior to expiry - so some time value is preserved - in instances where you feel more time is required. The new put will have a longer expiry, with the choice to nominate a different exercise price.
When rolling over, if the exercise price is the same or higher, you will generally need to pay a cost difference between the premiums, which reduces your breakeven point on the charts by that amount. If the premium is lower - sometimes for options with a lower exercise price - you may recoup some profits. In either case, buying more time may not necessarily be the best strategy, versus closing the position.
You generally buy put options when you expect asset prices to fall and implied volatility to rise
Put options provide time to weigh your rights over an asset at a fixed sell price, plus limit your risk to just the option premium while still gaining leverage to profits
Risks concern neutral or positive movements in the underlying asset price, time decay until expiry, and a decline in implied volatility
A put option’s breakeven point is its exercise price less its premium
Puts with the lowest exercise price often have the lowest breakeven on the chart and lowest premium and vice versa for those with the highest exercise price (high breakeven, high premium)
Long term puts have higher premiums and lower breakeven points on the chart - more exposure, but more time
At expiry, there is no time value in a put, profits are its intrinsic value less its premium
Puts can be sold, exercised or rolled over at or before expiry, depending if in the money or not, and whether you already hold the underlying asset