Put Options
A derivative that provides you with leverage during downtrends, while limiting your risk. The catch is that you have to be right on time.
Put Options - Details
A put option is an agreement that gives an investor the right (but not the obligation) to sell a stock, bond, commodity, or other instrument at a specified price within a specific time period. He/she profits on a put when the underlying asset decreases in price.
More specifically, put options can be divided into two types:
- Long put
- Short put.
In most cases these are non-delivery options, which means that an investor does not actually exercise their right to sell an asset at a specified price but rather settles for an appropriate cash amount. Still, in most cases, traders sell options before they expire (options that is). This will be explained on an example shortly.
An investor has a long put option on their hands when they buy an option agreement in which they are entitled to receive money when the price of an underlying asset is below a specified level, which level is called the strike price.
Put Options on Gold - Example
In a quick example, gold trades at $1,800. An investor buys a put option for $20 which allows them to cash in the positive difference between the price of gold and $1,600 in a year. If the price of gold rallies instead of declining and after one year is above $2,000 then the investor does not lose any money beyond what he has paid for the option - $20 in this case.
There are two possible scenarios. In the first one, after one year gold is above (or at $1,600). The investor does not receive any money and, all in all, they have lost $20 paid for the option itself. The second scenario is that the price of gold after one year is below $1,600. The investor exercises their right to receive money.
Depending on how much below $1,600 gold trades, the investor will end up with profit or loss. If gold is at $1,400, then the investor cashes in $200 ($1,600 - $1,400), but they still need to remember they have paid $20 for the option. So, at the end of the day, they arrive at a profit of $180 ($200 - $20).
If after one year gold is at $1,590, then the investor receives a payoff of $10 ($1,600 - $1,590) but still needs to factor in the $20 they have spent on the option. They end up with a loss of $10 ($10 - $20 = -$10, which is a loss).
We have described the payoffs of a buyer of a put option. How about its issuer (or seller)? Such an issuer (usually an institution rather than an individual investor) is the party which has to pay money if the price of the underlying asset is below the agreed level (the strike price). They have a short put option on their hands.
In our example, if gold ends up at $1,400, the issuer has to pay our investor $200. However, the issuer already has received $20 for the option. So, the final result for the issuer is a loss of $180 (-$200 + $20 = -$180). To be precise, it would be a bit less than -$180, because the institution would likely earn interest on the $20 during the year. On the other hand, if gold winds up at $1,600 (or above), the issuer does not pay the investor anything and the end up with a profit equal the amount they received for the option – that is $20 (plus interest that they earned on that sum during the year).
Asymmetry of Risk
The interesting property of options is that the investor which holds a put option risks only with the amount they pay for the option (in our example it is $20). They have the right, but not the obligation to exercise the option. So, their downside is limited. Their upside is also limited as the price of gold itself has limited downside potential.
However, the issuer of the option faces an inverse setting. They can gain only the amount they receive for the option (our $20) but they are obliged to pay any amount resulting from the price of the underlying asset at the end of the contract (so, if gold were at $500, they would still have to pay out $1,100). The downside potential clearly exceeds upside potential here.
The fact that the buyer can gain a lot (in theory of course) and lose only a specified amount while the issuer can gain only a limited amount of money and lose a lot (once again, in theory) is called the payoff asymmetry (or asymmetric payoffs) which translates into an asymmetry in risk.
So why do even market players engage in short options if the downside risk is great? The answer is that they set the option price at a level which they deem as high enough to offset the chance of ending up in the red. Plus they are certain to cash in option’s price right away, while the one that purchases the option only has a chance of making a profit in the future.
You Have to Be Right on Time
The main problem with being on the buying side in a put option deal is that the premium one pays (the price of an option) is usually considerable. What is more, to profit on a long put option one has to properly time their bet. A put option is a you-have-to-be-right-and-right-on-time kind of contract. The first part (being right) is quite straightforward: an investor speculating with a long put option anticipates the price to fall below the strike price. If the price goes in that direction and exceeds the strike price by more than the option premium (the price one pays for a put option), then they may profit from such a move (and gains can be truly spectacular). The second part is a little bit more complicated (being right on time): the anticipated price move (down) has to happen within the contract period. Note that the above-mentioned example said about gold moving to a given price in year. If gold moved to this price – but in two years, and it would do nothing during the first year – the option holder would lose everything.
There is more to it: once an investor is in a position to make profit on the put option, they have to decide whether they want to realize their gains or they believe that the price of the underlying asset will go even lower. If they decide to wait for a further move down, such a move has to occur relatively quick or be of relatively high magnitude.
Why? The answer is that options have a property to lose value in time. If the investor has an option which entitles him to receive money, they can sell this option at profit. However, if they decide to wait and a further move up does not materialize, the option is likely to be worthless. This phenomenon is called time decay.