Buying Put OptionsOptions
Put Options give the buyer the right to sell an underlying asset to the put option’s writer at the exercise price at or before the expiration date. The price paid for the right to sell the underlying asset is the premium. A put buyer’s goal is to sell an asset for more than its worth. The buyer of a put option anticipates the underlying asset’s market price falling below the exercise price. This allows them to exercise their put options and sell the underlying asset for a higher exercise price and earn profit. The writer of a put option expects the price of the put option to rise or stay the same price, so they won’t incur a loss by paying more for an asset than it is worth. If the underlying’s market price falls below the exercise price, the put options are “in the money” for the buyer. If the underlying’s market price is above the exercise price, the put options are “out the money” for the buyer. The formula for a put holder’s profit is as follows:
(Where market price is the underlying price at any point for an American style put option, at expiration for a European option, or average market price before expiration for an Asian style option)
The exercise price minus premium paid and commission & transaction fees are the breakeven point for a put holder, the strike price must be lower than this number for profit. If it is higher, losses would be incurred.
If the buyer exercises put options, the writer must buy the underlying asset from the buyer. If the buyer of the put options does not exercise their put options, the writer earns the premium as profit. The premium is the maximum downside for the buyer. A rational holder would exercise the option only if the underlying asset’s market price is less than the exercise price, making the premium the maximum potential profit for the writer.
The put’s value increases as the underlying asset’s market price decreases, since the underlying asset more likely to become “in the money”. If it is “in the money”, it is more likely to be exercised as the price falls. As the underlying market’s price increases, the put’s value decreases. It is cheaper for a buyer to purchase an “out the money” put with a low strike price, but it is riskier since it has a further distance before it falls below an exercise price. Despite being cheaper, “Out the money” put options are still harder to sell after their original purchase. “In the money” puts are far more likely to be purchased despite being more expensive after initial purchase.
A put holder does not have to actually own the underlying in advance to exercise the sale. This is referred to as a naked put. If they are exercising put options for profit, they can purchase the underlying asset when exercising the put and sell it immediately for profit. A put purchase on an underlying that is already owned is referred to as a covered put. It actually reduces profit to purchase the underlying at a higher price, then purchase a put, only to have the underlying market price drop and then exercise. There is less risk to a covered put, since holders don’t have to worry about acquiring the investment to sell. Coincidentally, it may be easy to acquire underlying assets after prices have dropped: lower prices imply others have been selling their holdings of the asset.
If you’re holding a position that you’d happily want to sell if the position crashed, purchasing a put option against the position is a smart move. If you bought an underlying asset at a market price of $30 which increased to $45, you buy a put that is exercisable at a strike price of $40. This protects against price falls beneath the $40 level until the exercise date. If market price falls to $35 you simply exercise the option selling the underlying at the strike price, and collect $40 per unit of the underlying asset. This is known as a “protected put”, and it saved you a $5 loss.
If you wanted to hold the investment, you could sell the “in the money” puts and collect the compensation. You can also sell the put position and use the earnings to buy a lower priced “out the money” put if you expect prices to continue to fall.
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