Table of contents:
- 1 The long put in the option chain
- 1.1 The Long Put (purchase of a put option)
- 1.2 The intrinsic value
- 1.3 And the time value
- 1.4 The European way
- 1.5 The long put as a hedge
- 1.6 Hedging an existing equity position (hedge)
- 1.7 It’s not quite that simple.
- 1.8 The risk with more contracts
- 1.9 The profit and loss profile
- 1.10 The price trend
- 1.11 Bid and offer price
- 1.12 Back to the P&L chart
- 1.13 Price difference to the Call – the Skew
- 1.14 The skew in the diagram
- 1.15 The skew in the option chain
- 1.16 Exceptions and special cases with skew
- 1.17 Advantages and disadvantages of the long put
- 1.18 Conclusion on long put (purchase of a put option)
Long Put: Welcome to my second article in the series, in which I introduce the basic building blocks of options trading.
I introduced the basic terms of options trading in the first article of the series, where we dealt with the “long call”. There you will also find information about the structure of options. And in addition a short treatise on the Greeks. This article will deal with the “long put”, i.e. the purchase of a put option.
The long put in the option chain
For a better explanation I have also chosen an example trade for the long put. The picture shows the option chain of Target (US abbreviation TGT). The puts can be found in the example of the broker Captrader on the right side. Unlike the call, the prices for the put options decrease with lower strikes. This results from the definition of the rights and obligations of a put option.
The Long Put (purchase of a put option)
In the case of a put option, too, the price is determined by the distance between the strike price and the market value of the underlying, among other parameters. If the strike price is higher than the market value of the stock, the option is “in the money”. It then has an intrinsic value and a time value.
At this point, let’s take a look at the rights and obligations. The buyer of a put option acquires the right to sell the underlying asset at the strike price. His only obligation is to pay the price for the option. In the example, an option contract relates to 100 shares. Therefore, the price of an option must be multiplied by 100.
For the example, let us assume that a trader buys a put option on Target with a strike price of 90.
The intrinsic value
The intrinsic value now arises in the following way. The holder of this long put option could buy a package of 100 shares at the current price of USD 86. An American-style option can be exercised on any trading day during its term. Therefore, the trader could immediately sell the block of shares at the strike price of $90 by exercising the option.
In this case, the seller of the put option is obliged to buy the 100 shares at the strike price.
The calculation is shown once in a formula:
- Net Asset Value (Put) = Strike – Price, calculated with the values from the example = $90 – $86 gives $4 (x 100 shares per option contract)
If the result is a negative value, the option is out of the money. The intrinsic value is then zero.
And the time value
Now the trader is happy for a short moment. After all, he has an immediate profit of $400, but for buying the option he has paid a premium of $505. The difference of $105 equals the current time value of the option contract. The current delta of -0.7 can also be seen as a 70% chance that the option will be in the money with the 90 strike on the expiration date. This chance is therefore worth 105 US dollars in the current market environment.
Because an option always has a time value. Even if this time value moves towards zero on the expiration date. Therefore, before an option is exercised, it should be considered whether it makes economic sense. The time value would be lost in this case. It is often more lucrative to resell the option, including the time value still inherent in it.
Again, a small formula for options that are quoted in the money:
- Time value = option price – intrinsic value, in this example the last price of $5.05 – $4 = $1.05 (x100 shares per option contract)
For out-of-the-money options, the option price is equal to the time value.
The European way
In contrast to this, European-style options can only be exercised on the expiration date. However, the majority of all traded options are American-style. Since this also applies to European stock exchanges, the term is somewhat misleading. It is important to check what type of option is involved before placing an order.
The long put as a hedge
Professional investors and large funds sometimes own huge blocks of shares. Here, a quick exit from these positions is almost impossible. If stop-loss orders of this size were to be torn when prices fall, this enormous volume would be added on the seller side. As a result, the downward movement would accelerate massively.
Originally, options were used by these market participants as hedging instruments. Over time, however, traders have seen a variety of options. Simple and complex strategies emerged, even without the need for hedging.
With an appropriate number of option contracts, unfavourable price fluctuations can be compensated for a while. By exercising the contracts, the shares can also be sold at the strike price. This would define the possible loss in advance.
Individual equity positions can also be hedged against price losses for private investors. Or, for example via index options, the entire portfolio. If a portfolio is geared to retirement provision, this option should at least be considered in uncertain market phases. Options are tradable on many ETFs, so that good combinations are also possible here.
Hedging an existing equity position (hedge)
Using Target as an example, we can explain this in more detail. Let’s assume that the example trader is in possession of 70 Target shares. From the previous article it is known that with a delta of 0.7, the option price changes by $0.70 if the price of the underlying asset changes by one dollar.
- 70 shares fall by one dollar = $70 loss
- At the same time the put rises with delta -0.7 in value = $70 profit
It’s not quite that simple.
Due to the interdependence of the Greeks, the parameters are constantly subject to dynamic change. If the price falls, the implicit volatility usually increases. The delta would also increase. This would compensate for the loss of the equity position even before the price has fallen by one dollar. However, I do not want to overstress the term “fundamentals”.
To keep it simple in thought, let’s assume that the delta remains constant despite the price change. This means that the long put with a 90 strike would be the best choice for this moment in order to secure the position against an impending crash. Should the price stagnate, the trader would still have the intrinsic value after the time value loss. This would have paid a premium of $105 for the insurance. If the price of Target rises, the put loses comparable value. In this way, the current profit or loss of the stock position would be frozen for the moment.
On the other hand, it must be taken into account that a strong price increase would be accompanied by a faster loss in value of the put. The intrinsic value is then quickly depleted. In this case, the insurance would be bought at too high a price. Taking into account the skew mentioned further below, the example trader could also look for options with a lower delta and adjust the number of contracts to the equity position. This would reduce the total premium.
The risk with more contracts
In this case, the invoice could look like this: Instead of a delta -0.7 contract, ten contracts are bought on Strike 75 with a delta -0.07 At the mid-price of 0.33, the total premium (without taking into account the fees) would be $330. Consequently, hedging the position $505 – $330 = $175 could be bought more cheaply? At first glance, yes, but there is one thing to consider: the intrinsic value of the position is completely out of the question. The $105 time value (= probable loss) is replaced by $330.
Depending on market sentiment and the individual orientation of the portfolio, each of these tactics may be justified. These examples are not a blueprint for a guaranteed hedge. They are only intended to illustrate how options work.
The profit and loss profile
From the knowledge gained so far, it can be deduced that a put option increases in value as the price of the underlying falls. A prerequisite for this is that influencing factors, such as the Greeks, remain constant.
If the market situation changes, the price of an option can fluctuate considerably during its term. This has either a favorable or unfavorable effect on the trade. In order to get a better overview of the possibilities of a purchased put option, I use the P&L profile software from Optionsuniversum again at this point.
If you want to get more information about this software, please follow this link:
For the example in the P&L profile I have chosen a strike of $82.50 and a remaining term of 51 days. This option costs $1.44. To earn the cost of the option, the price of Target should fall below the strike price by just that amount:
- Breakeven (Put) = Strike – Option price, in the example $82.50 – $1.44 = $81.06
The price trend
The small blue circle in the middle of the graph indicates the current price of Target. Although the trader has paid $144 for the put option, the account balance does not change. The option booked in return still has the time value equal to the price paid. This means that the profit or loss immediately after the purchase is a few dollars.
Bid and offer price
As with many financial instruments, options are subject to bid and ask prices. Depending on the underlying asset and the amount of options traded, the spread between the two prices (the bid-ask spread) can be enormous. Even if liquid options only have a narrow spread, a limit order is generally recommended in options trading.
As an indication of a fair price, I have the last price displayed in the option chain in addition to the bid and ask price. A “C” in front of the price means “close” (closing price of the previous day) and indicates that the option has not yet been traded in the current session. Also helpful is the “Mid” price, which represents the average between bid and ask.
Based on the motto “buy cheap and sell dear”, I set the limit order for a buy below the mid or last price. If there is no immediate execution, the limit is increased step by step. For the sale, the opposite procedure is followed and the order is worked downwards from the ask price.
Back to the P&L chart
If the price of Target and the Greeks remain constant, the blue circle would fall to the bottom line during the time to expiry. At that point, the $144 paid would be lost at any price of Target above $82.50.
In contrast, a price movement of the underlying instrument can be interpreted as a revaluation of the company by market participants. The resulting change in the supply and demand for the shares available on the market also brings about a change in the variables. This changes the implied volatility and also the value of the time factor.
Consequently, the prices of the options rise or fall, as does the current profit or loss of the position. The software can recalculate this using the current data via a connection with the broker’s software. The chart is then adjusted accordingly.
In this way, the trader is kept up to date on the development and prospects of his position. Currently, this put has an approximately 30 percent chance of going into the money by the expiration date. As a rule of thumb, the delta of almost 30 can be used. For a put, the delta is given with a negative sign.
Price difference to the Call – the Skew
After the crash of 1987, it became apparent that the pricing of stock options differed significantly from the values determined by the Black and Scholes model. As a result of supply and demand, different values for implied volatility are found at the various strike prices.
I refer to the generally accepted fact that stock markets generally rise moderately as a “regular market”. On a long-term average, the indices are assumed to show an average annual profit of six to ten percent. Outliers are often called hysteria or crashes.
In a regular market, the mass of players in the mode “stocks long”. Here, there is a need for hedging. This creates an increased demand for supposedly cheap puts out of the money. In addition, share owners sell out-of-the-money calls to generate additional income. This simultaneously leads to a higher supply of calls.
The skew in the diagram
The word “skew” means “skewed” and highlights this imbalance in prices. Shown as a diagram, the result is a curve that resembles a skewed smile. Sometimes the term “smile” is also used when referring to the “skew of volatility”. The following diagram from the “TraderWorkStation” trading software shows a representation for the options on the Target share
At the lowest point of the curve, supply and demand for options at this strike price are nearly balanced.
The skew in the option chain
Even without a graphical representation, indications of a different evaluation of the individual strikes can be found. In the option chain there is a delta value for each strike. We look for similar delta values on the put and call side. With a delta around 13, the call at mid-price is approx. 25 percent cheaper than the comparable put. In other words: the 13 percent chance that the option is in the money on the expiration date is traded higher on the put side.
Exceptions and special cases with skew
In the majority of cases the skew runs as shown with the emphasis on the put side. Deviating from this, it can appear symmetrical. For example, the imminent approval of a drug may create a balanced situation for a pharmaceutical company. Furthermore, rumours of a possible takeover can cause an “up-crash”. The prospect of hitting a jackpot with the right call then makes many speculators pay higher prices.
Advantages and disadvantages of the long put
Also in the case of the put, an advantage is the maximum risk limited to the premium paid. Speculation on falling prices of an underlying asset can be implemented in a defined way. A short position in shares involves certain risks. Outside trading hours, information can be published that suddenly pushes up the price when opening. This gap risk is not excluded with a put option. However, the potential loss is limited to the premium paid.
In contrast to the call, long puts are more often suitable for hedging strategies. In order to avoid having to use a stop-loss to fish fondly acquired shares out of the portfolio, market weaknesses can also be overcome with puts.
In my opinion, the biggest disadvantage of purchased options is that even with a correct assessment of the price movement, a loss can occur. The underlying asset must move depending on the strike selection to compensate for the time value paid.
Conclusion on long put (purchase of a put option)
In my opinion, the purchased put has a higher value than the call. Whether as an instrument for hedging or to implement short strategies. Taking into account the liquidity of the options, a downward trend of the underlying asset can be traded profitably. The risk of high losses due to sudden up-gaps can be limited very well.
The skew is a tool that helps to estimate option prices. By comparing the prices of puts and calls, the current valuation of certain price marks can be identified. The position of the skew can provide an indication of the market situation of the underlying asset (normal mode in need of hedging, balanced or jackpot mood).
In the next article we will switch to the seller side. I will reveal the mystery of the Skew deals. Sometimes option sellers also believe that they have the probabilities on their side. It all seems to be connected somehow, so that the next step into the world of options is a bit bigger.
Read my other posts about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?