CHAPTER
9

Put Strategies

In This Chapter

• How puts work
• Using puts for hedging and speculating
• Complicated strategies for occasional use only
• Other put strategy information you need to know

Want to get rid of something? In trader terms, you put it to someone else. If that item has gone down in value, the ability to put it to someone else is a great thing. A put option gives the holder the right to sell an asset to someone else at a predetermined price. If the asset falls in value, the put holder makes money.

Because puts come in-the-money as the underlying price falls, they are often considered to be bearish. Some people even think it’s bad to profit on a decline in price. But puts don’t have to bearish, and a price decline isn’t always bad news. Put strategies offer different ways to speculate and hedge on the prices of stocks and other assets.

The vertical axis is the amount of profit you receive, and the horizontal axis is the price of the underlying asset. The axis crosses at 0 profit to show when the option is profitable and when it is unprofitable to the holder. When a put option is purchased, the position is a loss equal to the amount of the premium.

For example, you buy a March put on an asset with an underlying price of $118. The strike price on your put is $100, and you pay a premium of $4.55. If the asset falls to $90, you would be able to buy the stock at $90 and sell it to the put writer for $100, for a profit of $10. Of course, you’d have to subtract the $4.55 premium paid, so your profit would be $10.00 – $4.55 = $5.45.

If the underlying asset is at $100 or above at expiration, you would not ordinarily want to exercise the option, so you’d be out the $4.55 cost.

With a long put position, you lose the premium amount, no matter what happens to the strike price. Your position is considered to be in-the-money as soon as the underlying price exceeds the exercise price, but it is only profitable to exercise when the underlying hits a price below the sum of the strike price minus the put premium.

Still, it is worthwhile to exercise the put option at any time that it is in-the-money, because exercise will reduce the amount of the loss you have.

If you write a put—also known as the sale of a put, or being short a call—you receive the premium. In exchange, you agree to buy the underlying at a specified price in the future, should the buyer choose to exercise it. In general, the price that makes assignment profitable is a price that is higher than the market value.

The payoff from the short put position can be illustrated like this:

A short put is profitable as long as the price of the underlying asset is below the strike price.

As with the long put payoff graph, the vertical axis is the amount of profit you receive, and the horizontal axis is the price of the underlying asset. The axis is drawn at 0 profit helps illustrate when the short put becomes unprofitable to the writer. The writer keeps the premium no matter what happens to the underlying. The writer must buy the underlying asset if the put goes into the money. (Sure, the holder has the right to exercise at any time and at any market price, but it is only profitable to do so if the put is in-the-money. It makes things easier to assume that traders are rational. However, who knows what goes through people’s heads some days.)

And just as the long put profits from the same market conditions as a short call, the short put behaves similarly to a long call.

With a short-put position, you keep the amount of the premium, no matter what happens to the strike price. The position is considered to be in-the-money at prices above the exercise price.

The losses on a naked short put can be huge—you might have to buy an asset that goes all the way to 0. One way to hedge is with the purchase of a put with a lower strike price (also known as a bull-put spread). Don’t assume that it can’t happen to you! The financial markets are very strange.

The following table offers a summary of the profits and losses involved with different put positions.

Economics of a Put Option on a Single Stock

	Buyer	Writer
At purchase	Pays premium	Receives premium
In-the-money	Sells stock	Receives stock
Out-of-the-money	Loses premium	Keeps premium
Upside potential	Strike price minus market price minus premium	Premium value
Downside potential	Premium value minus market price	Strike price plus premium
Market view	Bearish	Bullish

Long Put Strategies

The starting point for a review of uses of puts is simple: what happens if you buy a put? You want to be long a put if you want to bet on the price of the underlying asset going down. The reasons for taking this proposition may differ.

Hedging

A put holder might be hedging against the decline of a price in the underlying security. A put is a great form of insurance on prices, which is useful for anyone who does not want to lose wealth from a price decline.

Speculating

A speculating put holder is betting that the underlying asset will decline in price. This is a bit risky because most markets have an upward bias in prices. If we assume that the economy is growing, then prices should increase by the rate of inflation. That’s the tendency that a put holder is fighting when he or she is speculating on the market.

Short Put Strategies

A short put is the mirror of a long call. It is bet that the price of the underlying will close above the strike price at the expiration date. And like any put or call, it has many uses.

Hedging with Short Puts

Short puts are a way to hedge against the price of an asset rising in the sense that an increase in the asset price is offset by the premium received for writing the put.

Now, you might be thinking that an increase in the price of an asset is a good thing, but that is not always the case. Think of a business that has expenses in yen. If the yen increases relative to the dollar, then the business’s costs will go up. One of the many ways to hedge against this would be to write puts, collecting income to offset the effect of a stronger yen.

Speculating

When writing a put, the seller is looking to generate income. She will be able to do so as long as the price of the underlying does not fall below the strike price at expiration. There is considerable risk, though, so few put sellers are willing to write puts without using other types of options for protection.

But, you might be thinking, wouldn’t a call writer have the same risk? After all, a stock can, in theory, go up to infinity, and it can only go down to 0. That’s absolutely true, but most call-writing income strategies are based on covered calls. If you write calls on assets you already own, then you have some protection if your call is exercised. It doesn’t work that way with puts. If you write puts on an asset you already own that go down in price, you still must buy more of the asset at the strike price when the underlying goes down.

The Put and the Premium

Put options are affected by the price of the underlying, the price and date of exercise, the amount of volatility, and interest rates. The following table summarizes the effects of the price factors.

Market Factor	Long Put	Short Put
Underlying price	Decreases	Increases
Exercise price	Increases	Decreases
Volatility	Increases	Decreases
Time to expiration	Increases	Decreases
Interest rate	Decreases	Increases
American option	Increases	Decreases
Dividend	Increases	Decreases

Put Strategies

Some buyers and sellers of puts are interested in puts alone, but most use them as part of more complex strategies. This section is a rundown of many of the different ways that puts can be used, alone and with other contracts.

Protective Puts

A protective put, sometimes called a covered put, is a long-put position combined with a long position in the underlying asset. This is one of the most common uses of puts because it’s obvious and it works.

For example, suppose you own an underlying asset with a market value of $100. You do not want to lose more than 15 percent of its value, so you buy a put with a strike price of $85. If the price of the asset falls by more than 15 percent, you can exercise the option and sell your underlying for $85. If the underlying is above $85, then you lose the cost of the premium. That’s how insurance works, after all.

Naked Puts

The thing about writing puts is that there’s no way to hedge it with assets you already own, other than with cash. Most put writers are using other options to manage their positions, but some choose to write options naked—that is, with no coverage. This is risky, but if you want to do it, here’s the usual technique: writing deep out-of-the-money puts. These are puts that are very unlikely to go in-the-money during the holding period, such as puts on a 20 percent decline in a stock market index over the next month. Can it happen? Sure. There are a few huge one-day declines in the history of the financial markets. Is it likely? Well, it’s hard to say.

For example, consider OEX put options. These are Chicago Board Options Exchange options on the S&P 100 Index. On a day when the index is at $875, you see that the premium for December put options with a strike price of $320 are trading at $2 each. How likely is it that the index will fall by more than half between now and expiration? Not very. Could it happen? Sure! And if that happens, you will be out a lot of money.

Some algorithmic programs use puts on unlikely price declines as part of complex portfolio insurance strategies. The downside, of course, is that a calamity in the financial markets will make these go in-the-money with very little warning—and very big losses for the writer. Tread carefully.

Put Spreads

Put spreads involve the purchase of one put and the sale of another. They not only help manage the risk of writing a naked put, but they also offer a range of ways to hedge and speculate. All you have to do is put them together! (I know, bad pun.)

The two options in a put spread differ on one feature, such as strike price or expiration. Because of this, they have different premiums and different expected price movements.

Bull-Put Spread

Although the put is a bearish option, put strategies are not necessarily bearish. A great example is the bull-put spread, also known as a credit spread. In this, you sell a put with one strike price and buy a put with a lower strike price. You have the premium and some protection.

For example, say you write a put with a strike price of $37 for a premium of $0.08. Then, you buy a put with a strike price of $30 and a strike price of $0.01. Your net credit position from the premiums is $0.07. If the underlying closes above $37, you keep the premium. If the price slides below that, you might be assigned the option and buy the stock at $37. If the underlying goes below $30, then you can put it to the trader who wrote your option for a maximum loss of $37.00 – $30.00 = $7.00, offset by the $0.07 premium credit for a net loss of $6.93.

Here’s what that looks like on a graph:

A represents the strike on the long put, and B represents the strike on the short put.

The maximum payoff is the difference between the premium received and the premium paid. The maximum loss is the difference between the strike prices minus the difference between the underlying premiums. This is a mildly bullish strategy because it is profitable when asset prices close above the strike price at expiration, but its losses on the downside are limited.

Bear-Put Spread

A bear-put spread involves buying a put with one strike price and then writing a put with a lower strike price. The premium paid on the put purchased will be higher than the premium received on the put written. This is because the put purchased will be closer to the money in value.

The maximum profit on a bear-put spread is the difference in the strike prices minus the net debit position from the net premium paid, provided the underlying security is below the lower of the two strike prices. The maximum loss is the difference in premiums paid—much less than with a naked put.

A represents the strike on the short put, and B represents the strike on the long put.

Married Puts

A married put strategy is the purchase of stock and put options to cover the same number of shares. It’s a form of protective put strategy, and it is a form of a put spread. It’s like two strategies in one!

The put position limits the risk of the stock because if it falls in value, then it can be sold at the exercise price of the puts.

Let’s say you buy 100 shares of stock at $22.61 and one put options contract with a strike price of $22 to cover 100 shares at $1.85 per share. If the stock increases in value by more than $1.85 between the initiation and the expiration, then you profit from the upside. If it sells for less than $22, you can exercise the option.

Of course, you can set any strike relative for the option, which is where the spread part of the strategy comes in. Normally, the put would have a strike at or below the current price of the stock, but how much lower would depend on how you’re feeling about the market. The further out-of-the-money, the lower the cost of the put—but the less protection you have.

The following table offers more information on put-spread strategies.

Economics of Put-Spread Strategies

Calendar Spread

A calendar spread, also called a time spread or a horizontal spread, involves buying a put with one expiration date and selling a put with a different expiration. This is a play on the time value and volatility of the options.

For example, you can buy an April 40 put for $0.39 and then sell a July 40 put for $0.66. The net premium here is $0.66 – $0.39 = $0.27. If the underlying is below $40 at or before the April expiration, you can exercise the put that you bought. Of course, if the underlying is below $40 at or before the July expiration, you might have to buy it at a loss.

Butterflies

If you squint, the payoff graphs for these spreads look a little like butterflies. Maybe? Sort of?

No matter what they look like to you, butterfly spreads are plays on volatility more than on prices going up or down. The trader is trying to determine if the market is likely to be extremely volatile or have no volatility at all when structuring butterflies.

Long-Butterfly-Put Spread

A long-butterfly-put spread is the combination of a bear-put spread and a bull-put spread. A trader sets it up by selling two at-the-money puts and buying one in-the-money put and one out-of-the-money put on the same underlying asset with the same expiration date. The two short puts have the same strike price, with one long put having a greater exercise price, and one long put having a lesser one.

Let’s say you set up one spread with the purchase of a 32 June put at $1.56 and the sale of a 34 June put for $1.98. Then, you set up a second spread with the purchase of a 36 June put at $3.05 and the sale of another 34 June put at $1.98. Your net premium here is –$1.56 + $1.98 – $3.05 + $1.98 = –$0.65. This net premium is the cost of your position, and the most money that you can lose.

The following graph shows the prices where the long butterfly put spread pays off and where it doesn’t.

A and C are the strike prices on the short puts, and B is the strike price on the long puts.

The loss on a long-butterfly-put spread is equal to the net premium paid to set it up. The potential profit is the difference between the long and short strike prices ($2 in the earlier example), less the net premium paid. A long butterfly allows a trader to profit on a modest decline in the underlying asset, but with much less downside risk than either a straddle or a strangle (covered in Chapter 10).

Short-Butterfly-Put Spread

As with the long-butterfly-put spread, a short-butterfly-put spread is the combination of a bear-put spread and a bull-put spread. However, the short-butterfly-put spread has different price points for the long and the short. A trader sets it up by buying two at-the-money puts, and selling one in-the-money put and one out-of-the-money put on the same underlying asset with the same expiration date. The two long puts have the same strike price. One of the short puts has a greater exercise price, and the other short put has a lower exercise price.

For example, let’s say you buy two 75 August puts at $2.86 each, for a total cost of $5.72. Then, you sell one 65 August put for $0.73 and another put, an 85 August put, for $11.02. You collect a total of $11.75 and paid $5.72 for a net premium of $6.03. That premium is yours to keep, and is your maximum profit.

The short butterfly put spread’s payoff is limited, as shown on the following graph.

A and C are the strike prices on the long puts, and B is the strike price on the short puts.

The potential gain on this transaction is limited the net premium paid. The potential loss is equal to the difference in strike prices minus the difference in premiums, or –$10 + $6.03 = –$3.93 in the preceding example. A short butterfly allows a trader to profit from volatility, but with much less downside risk than either a straddle or a strangle (covered in Chapter 10).

If you’re interested in butterfly strategies, consider the range of payoffs summarized in the following table.

Economics of Butterfly-Put Strategies

	Long Spread	Short Spread
To establish	Net premiums	Net premiums
In-the-money	Difference between the price of the underlying asset, strike, and net premium	Net premium
Out-of-the-money	Lose net premium	Lose difference between the price of the underlying asset, strike, and net premium
Upside potential	Difference between the price of the underlying asset, strike, and net premium	Net premium
Downside potential	Net premium	Lose difference between the price of the underlying asset, strike, and net premium
Market view	Neutral	Volatile

Condors

As you learned in Chapter 8, condors are like butterflies except they have a spread on the strike prices. This gives them a wider wingspan than the butterfly, hence the name.

They also offer more flexibility because they pay off on a wider range of prices. Like a butterfly, a condor is a bet on volatility. Unlike a butterfly, the volatility position need not be one of extreme volatility or extreme stability.

Long-Condor-Put Spread

A long-condor-put spread is similar to a long-butterfly-put spread, but with a wider range of prices where the position is at peak profitability. A trader sets it up by buying two out-of-the-money puts with different strike prices. She then sells one in-the-money put and one out-of-the-money put on the same underlying asset with the same expiration date, making sure that those strike prices are above and below the prices of the long puts.

The long condor put spread’s payoff is broader than with the butterfly, but it is still limited, as shown on the following graph.

A and D are the strike prices on the short puts, and B and C is the strike price on the long puts.

The profit on a long-condor-put spread is equal to the net premium received. The loss is limited to the difference in strike prices minus the net premium paid. A long condor allows a trader to profit when the underlying asset is not expected to change much in price. A long condor also has much less downside risk than either a straddle or a strangle and more flexibility than a butterfly.

Short-Condor-Put Spread

Just like the long-condor-put spread, a short-condor-put spread is the combination of a bear put spread and a bull put spread. It is established by selling two in-the-money puts, and buying one in-the-money put and one out-of-the-money put on the same underlying asset with the same expiration date. The short puts have an exercise price between that of the two long puts.

The following graph shows the payoff of the short condor put spread.

A and D are the strike prices on the long puts, and B and C are the strike prices on the short puts.

The potential profit on this transaction is the difference between the strike prices and the net premium paid. The potential loss is equal to the difference in premiums. A short condor allows a trader to profit from extremes in volatility, but with much less downside risk than either a straddle or a strangle (two volatility plays covered in Chapter 10).

If you’re interested in butterfly strategies, consider the range of payoffs summarized in the following table.

Economics of Condor-Put Strategies

	Long Condor	Short Condor
To establish	Net premiums	Net premiums
In-the-money	Net premiums	Difference between the price of the underlying asset, strike, and net premium
Out-of-the-money	Lose difference between the price of the underlying asset, strike, and net premium	Net premium
Upside potential	Net premium	Difference between the price of the underlying asset, strike, and net premium
Downside potential	Lose difference between the price of the underlying asset, strike, and net premium	Net premium
Market view	Neutral	Volatile

How to Think About Puts

Puts are bearish options, but often used as part of bullish strategies. Some of that is because of the risks inherent with naked puts and the inability to do a true covered put in the same manner as a covered call. (The analogue is a protective put. For that, you will be charged a premium instead of receiving it.)

The key is to think about puts as a way to buy a payoff, rather than something particularly bullish or bearish. Then, you can work puts to fit your needs.

The Least You Need to Know

• A long put position pays off when the underlying asset decreases in price. A short call pays off when the asset stays flat or increases in value.
• Long puts are generally used as bearish strategies.
• A protective put is a common hedge against a long position in the underlying asset.
• Long and short puts can be combined to play different aspects of price volatility.