Why do you buy put options and how do you calculate your profit?

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Susan Hayes writes: A put option is the right, but not the obligation, to sell a stock. It is, in essence, an insurance policy on a financial market security.

There are two reasons why an individual or institution might buy a put option;

(a) to protect a stock position (i.e. a protective put);

Let's say that I hold (i.e. long) a stock currently priced at $100. Now, let's say that the lowest price that I want to receive for that stock at some stage in the future (strike date) is $80 (strike price). Options are traded in block of 100 shares in the US market. I could pay a premium (e.g. $1 x 100) to lock in that price via buying a put option. I am buying the right, but not the obligation, to sell that block of 100 stocks at $8000 ($80 x 100) on a certain date in the future. As a result, I have put a "floor" under my stock. Ideally, of course, I don't use (exercise) that option at expiry. I would prefer if the stock rises in value and I can sell the security to the market at a higher price!

(b) To make a return in a falling market;

If a market participant has bought the put option, they are said to be “long” in this transaction. Using the insurance policy analogy, the more risky the scenario insured, the more valuable the insurance contract or "floor" is. As a result, if the stock is falling, the price of the put option goes up. This is a “bearish” strategy i.e. you would only buy a put option if you felt the market was going to fall. This is referred to a “naked” trade if you don’t own the underlying stock and the only reason that you had the option is to make money on the basis that the stock would fall and hence the value of the option would rise.

The maximum amount of loss that a put buyer can have is the premium that they pay at the beginning of the contract. In the numerical example above, all that you can lose is $10 plus your transaction cost. The is an upward limit also – the furthest the share can fall is to $0, at which you would make the maximum of $8000, as this is the difference between the strike price and the market price. In practice, there are a number of things to take into account throughout the life of the option.

Firstly, you need to decide the “strike price” to buy. This is the price that you have the right, but not the obligation to sell at. You might buy an option that is “out-of-the-money” or the strike price is below the current market price. In the above example, you would choose a strike price anywhere below $100. If the stock

goes up in value or is still at $100 by the time of the expiry of the option, you will lose your premium and hence, invoke the maximum loss. You may also buy an option that is “at-the-money”, i.e. the strike price is the same as that of the market. Again, if the stock rises or trades flat by the time of expiry, you will lose your premium. However, a trade might start off either “out” or “at” the money and the stock price could fall below the strike price.

In the above example, the price of the share falls below $80. Now this contract is “in-the-money” and you can “exercise” your option. This means that you could sell the stock at the strike price, which is higher than the market price. Have you actually made a profit? Indeed, you might have made money in the difference between the strike and market prices, but you also need to take away the premium that you paid as well as the transaction cost of doing so. Let’s say the market fell to $75 per share. You sold your holding at $80, since you had the put option to exercise. You made a gross profit of $5, but you need to subtract the $1 premium to find the net effect. In fact, you made $4 less the transaction cost from buying this put option.

By Susan Hayes

Susan Hayes is Managing Director of Hayes Culleton – a financial training and educational consultancy company, specialising in eLearning. Susan has a BSc Financial Maths & Economics and passed two of the Chartered Financial Analyst (CFA) exams on the first attempt. Hayes Culleton is a client of Enterprise Ireland as well as a corporate affiliate of Finance Malta. Susan has delivered financial training for Irish Times Training, Malta Institute of Accountants; Bank of Valletta as well as the InvestR Centre. In 2008, Susan wrote a digitised module called “Introducing Wall Street to the Classroom” designed to make the stock market approachable and accessible for second level students and their teachers. She regularly contributes to the national and international media including The Sunday Times (Malta), RTE, Newstalk and Today FM (Ireland), as “The Positive Economist” on matters relating to economics, the stock market, banking, entrepreneurship and finance. Within Susan’s own portfolio, she favours Exchange Traded Funds, Value Stocks and Writing Options.

Copyright © 2011 Susan Hayes - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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Category: Forex

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