Of course, puts can be a part of a host of different spreads, but this chapter discusses the two most basic and common put-buying strategies: the long put and the protective put. The long put is a way to speculate on a bearish
move in the underlying security, and the protective put is a way to protect a long position in the underlying security.
Consider a long put example:Buy 1 SPY May 139 put at 2.30 In this example, the Spiders have had a good run up to $140.35.
Trader Isabel is looking for a 10 percent correction in SPY between now and the end of May, about three months away. She buys 1 SPY May 139 put at 2.30.This put gives her the right to sell 100 shares of SPY at $139 per share.Exhibit 1.6 shows Isabel’s P&(L) if the put is held until expiration.If SPY is above the strike price of 139 at expiration, the put will expire and the entire premium of 2.30 will be lost.
If SPY is below the strike price at expiration, the put will have value. It can be exercised, creating a short position in the Spiders at an effective price of $136.70 per share. This price is found by subtracting the premium paid, 2.30, from the strike price, 139.This is the point at which the position breaks even. If SPY is below $136.70 at expiration, Isabel has a profit.
Profits will increase on a tick-for-tick basis,with downward movements in SPY down to zero. The long put has limited risk and substantial reward potential.An alternative for Isabel is to short the ETF at the current price of $140.35. But a short position in the underlying may not be as attractive to her as a long put. The margin requirements for short stock are significantly higher than for a long put.
Put buyers must post only the premium of the put—that is the most that can be lost, after all.The margin requirement for short stock reflects unlimited loss potential.Margin requirements aside, risk is a very real consideration for a trader deciding between shorting stock and buying a put. If the trader expects high volatility, he or she may be more inclined to limit upside risk while leveraging downside profit potential by buying a put.
In general, traders buy options when they expect volatility to increase and sell them when they expect volatility to decrease. This will be a common theme throughout this book.Consider a protective put example:This is an example of a situation in which volatility is expected to increase.Own 100 shares SPY at 140.35 Buy 1 SPY May139 put at 2.30
Although Isabel bought a put because she was bearish on the Spiders, a different trader, Kathleen, may buy a put for a different reason—she’s bullish but concerned about increasing volatility. In this example, Kathleen has owned 100 shares of Spiders for some time. SPY is currently at $140.35. She is bullish on the market but has concerns about volatility over the next two or three months. She wants to protect her investment.
Kathleen buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and the put at the same time, as a spread, the position would be called a married put.)Kathleen is buying the right to sell the shares she owns at $139.Effectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk profile of this new position.
The solid kinked line is the protective put (put and stock), and the thin dotted line is the outright position in SPY alone, without the put. The most Kathleen stands to lose with the protective put is $3.65 per share. SPY can decline from $140.35 to $139, creating a loss of $1.35, plus the $2.30 premium spent on the put. If the stock does not fall and the insuring put hence does not come into play, the cost of the put must be recouped to justify its expense.
The break-even point is $142.65.This position implies that Kathleen is still bullish on the Spiders. When traders believe a stock or ETF is going to decline, they sell the shares.Instead, Kathleen sacrifices 1.6 percent of her investment up front by purchasing the put for $2.30. She defers the sale of SPY until the period of perceived risk ends. Her motivation is not to sell the ETF; it is to hedge volatility.
Once the anticipated volatility is no longer a concern, Kathleen has a choice to make. She can let the option run its course, holding it to expiration,at which point it will either expire or be exercised; or she can sell the option before expiration. If the option is out-of-the-money, it may have residual time value prior to expiration that can be recouped.
If it is in-the money,it will have intrinsic value and maybe time value as well. In this situation, Kathleen can look at this spread as two trades—one that has declined in price, the SPY shares, and one that has risen in price, the put.Losses on the ETF shares are to some degree offset by gains on the put.