Risk and Reward Characteristics of Buying a Put Option
The profit and loss potential at expiration of buying
a February 100 put for $5 as stated. The put allows the
holder to sell the future at 100, so it will
generally not be exercised if the market is
above 100. The three scenarios outlined with the
call expiration entail the opposite results:
-
If the market is
below 100, the put should, and probably will, be
exercised because the holder can sell the future at
100, which is above the level the market is trading.
Assume the market is trading at 90 at expiration.
The put is exercised so the holder is 8hort the
market at 100 and can immediately buy the future at
90 for a $10 profit. The $5 price of the put is
subtracted against the $10 profit to arrive at a
total profit of $5, as shown on the graph. If the
future were trading at 95 then the holder would
breakeven.
-
If the future is
at 100, the put mayor may not be exercised since the
owner can sell the future in the open market at 100.
The maximum loss is $5 or the price of the put.
-
If the future is above 100 the put should not be exercised
and the
maximum loss is $5.
The
put does not have the upside risk associated with
selling the outright, because the maximum loss is
limited to $5. The put closely resembles the 45C
line and same profit and loss potential of selling
short the future at 95 if the market is below 100.
The
price of the put will move about the same amount as
the future if the future is below 80. The price of
the put will move from approximately 1/2 to 1 point
for each I-point move in the future between 80 and
100. The price of the put will move from 0 to 1/2
for each I-point move in the future between 100 and
120. The potential profit and loss line in the
present will vary greatly and approach the profit
and loss line at expiration, as in the call example,
due to the same reasons.
From
the preceding scenarios we see the loss is limited
in purchasing an option but the reward is not
limited for calls. The profit potential in buying a
put is limited to the underlying dropping to zero,
and therefore is not the same profit potential as
buying a call. The idea of limited risk and nearly
unlimited profit potential Is one of the most
alluring reasons why investors choose to buy
options. For every purchase there is a sale, so
let's review the other side of
option trading in the next section.
Risk and Reward Characteristics
of Buying a Put Option
