Saturday, September 15, 2012

Options 2.0 - Part 8. Basic Options Strategies; Short Put

The original column has been published (shortened) in Dutch on September 18 at Telegraaf's / Goeroes / Opties 2.0 – deel 8. Basis Optiestrategie; Short Put

Basic options strategies
In my previous article of September 7th, "Basic Option Strategies; Short Call", you read all about the third basic option strategy, the Short Call.
Today I’m going to cover the fourth basic option strategy: the Short Put

Short Put (Selling a Put option)
A Short Put consists of a single leg; the Sale of a Put option.
A Short Put becomes attractive when you expect either a neutral movement and/or an increase in the price of the underlying asset.
A Short Put can also be used to lower the purchase price of shares.

With a Short Put you’ll initially receive money. The investment amounts to the number of contracts that you sell x the Put option price x the contract size. If you sell 4 Put options for 6.50, then you’ll receive 4 * 6.50 * 100 = 2,600 Euros.

The Short Put strategy comes with a margin obligation. This means that you aren’t free to spend the received investment and that you must maintain a specific margin as security (to offset potential future losses) in addition. The Margin obligation is calculated and settled on a daily basis. And also intraday for the various banks and brokers.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price minus the price that you received for the Put option. The Put option now has only an intrinsic and no longer a time value. Which is why your result is 0.

You’ll make a profit upon expiration if the price of the underlying asset is above the break-even point.

Maximum Profit
The maximum profit that can be achieved using a Short Put is limited to the Put Option premium received. Upon expiration, the Put has a value equal to the strike price, minus the price of the underlying asset. If upon expiration, the price of the underlying asset is higher than the strike price of the Put option, then the Put option has no remaining intrinsic value. The Put option will expire at 0 and you’ll realise the maximum profit.

You’ll make a loss upon expiration if the price of the underlying asset is below the break-even point.

Maximum Loss (Risk)
Your maximum loss is equal to the exercise price of the Put option minus the purchase price of the Put option (so basically unlimited)! Thus the lower the price of the underlying asset, the greater the value of the Put option. And the greater your loss.

Price of the Underlying Asset (Delta) Influence
Positive. A Short Put has a positive Delta. A higher underlying asset price results in a lower Put option premium.

Remaining Maturity (Theta) Influence
Positive. Time works to your advantage with a Short Put strategy, because the remaining time value of the Put option reduces daily.

Volatility (Vega) Influence
Negative. A higher volatility indicates a greater remaining time value for the Put option and thus a higher Put option premium.

The advantage of the Short Put is that no price change is required to achieve a profit. For at-the-money and out-of-the-money Put options, a consistent underlying asset price is sufficient to achieve the maximum result.

The downside of the Short Put is that the maximum loss is “unlimited”.

Suppose that we sell a Put option on the AEX-index with a strike price of 335.00 for a price of EUR 6.50. The AEX lists it at 335.77 at that moment in time
One Put option provides an investment of -1 x 6.50 x 100 = - EUR 650.
The Put option premium includes a time value of 6.50 (= 100%). Thus 6.50 – intrinsic (= max (0. 335.00 – 335.77)) = 6.50 – 0.0 = 6.50. So, upon expiration the AEX price may drop by 7.27 (from 335.77 to 328.50 = -2.2%) in order to reach the break-even point. If the price is above 328.50 we would achieve a profit using this strategy. And if the price is above 335.00 (= -0.2%), we would realise the maximum profit using this strategy.

Upon expiration the outcome would be as follows:

Short Put Graphical Simulation:
The x-axis shows the various price levels of the underlying asset.
The y-axis displays the (expected) result. The blue line indicates the expected result one month prior to expiration. The red line shows the result upon expiration.

The most common pitfall for private investors using Short Puts is to wait too long to close the position and take their profit or loss.

This completes the 4 basic options strategies so far. It is conveniently summarised in the table below:
Next we can combine these 4 basic option strategies with a second leg. We do this by buying or selling other Call or Put options. This results in an options strategy that consists of two legs. We may also combine options with the buying or selling of the underlying asset.

Options 2.0 ... Options Strategies with 2 legs
In this article we’ve taken a look at the fourth basic option strategy with a single leg; the Short Put. And we’ve covered how to use it and what the advantages and disadvantages are.
In the next article we’re going to make a start on basic option strategies with two legs; we’ll begin with Call Spreads and continue onto Put Spreads, Straddles and Strangles.

Herbert Robijn is founder and director of FINODEX ( FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

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