You can hedge your stock positions by going long with puts.
Buying puts is a simple strategy that can help protect your assets in a bear market. If you think the market is going to decline, buying puts might be more advantageous than either selling the stocks you own or selling stock short through your margin account.
Trader Objectives
Put buying is a strategy some investors use to hedge existing stock positions. For the cost of the premium, you can lock in a selling price, protecting yourself against any drop in asset value below the strike price until the option expires. If you exercise your option, the put writer must purchase your shares at the strike price, regardless of the stock’s current market price. But if the stock price rises, you’re still able to benefit from the increase since you can let the option expire and hold onto your shares. Your maximum loss, in that case, is limited to the amount you paid for the premium. Speculators who forecast a bearish equity market often buy puts to profit from a market downturn. As the price of the underlying equity decreases, the value of the put option theoretically rises, and it can be sold at a profit. The potential loss is predetermined—and usually smaller—which makes buying puts more appealing than another bearish trading strategy, selling stock short.
Getting Married
If you buy shares of the underlying stock at the same time that you purchase a put, the strategy is known as a married put. If you purchase a put on equity that you’ve held for some time, the strategy is known as a protective put. Both of these strategies combine the benefits of stock ownership— dividends and a shareholder’s vote—with the downside protection that a put provides. Holding the underlying stock generally indicates a bullish market opinion, in contrast to other long put positions. If you would like to continue owning a stock and think it will rise in value, a married put can help protect your portfolio’s value in case the stock price drops, minimizing the risks associated with stock ownership. In the same way, protective put locks in unrealized gains on stocks you’ve held, in case they begin to lose value.
Short a Stock or Long a Put
If you sell stock short, you borrow shares on margin from your brokerage firm and sell them on
the stock markets. If the stock price drops, you buy the equivalent number of shares back at a lower price and repay your brokerage firm. The difference between the two prices is your profit from the trade. For many traders, buying puts is an attractive alternative to shorting the stock.
| Shorting | Buying Put |
|---|---|
|
Shorting stock requires a margin account with
your brokerage firm. A short seller also faces the
possibility of a margin call if the stock price rises,
and could be forced to sell off other assets. |
Puts are purchased outright, usually for a much
lower amount than the margin requirement,
so you don’t have to commit as much cash to
the trade.
|
|
Shorting stock involves potentially unlimited loss
if the price of the stock begins to rise and the
shares have to be repurchased at a higher price
than they were sold.
|
A long-put poses much less risk to an trader
than shorting the stock. The holder of a put always
faces a predetermined, limited amount of risk.
|
Calculating Return
Whenever you buy a put, your maximum loss is limited to the amount you paid for the premium. That means calculating the potential loss for a long put position is as simple as adding any fees or commissions to the premium you paid. You’ll realize this loss if the option expires unexercised or out-of-the-money.
If you anticipate experiencing a loss and sell your option before expiration, you may be able to make back some of the premium you paid and reduce your loss, though the market price of the option will be less than the premium you paid.
1) Purchasing to Hold or Sell the Option
If you purchase a put and later sell it, you can calculate return by figuring the difference between what you paid and what you received. For example, say you purchase one ABC put for Rs.300, or Rs.3 per share. A month later, the price of the underlying equity falls, placing the put in the money. You sell your option for Rs.600, or Rs.6 per share. Your return is Rs.300, or 100% of your investment.
Rs.600 Sale price – Rs.300 ABC put price
= Rs.300 or 100% return
If the price of the stock has risen after a month, the put is out-of-the-money, and the premium drops to Rs.200. You decide to cut your losses and sell the put. You’ve lost Rs.100, or 33% of your investment.
Rs.300 ABC put price – Rs.200 Sale price
= Rs.100 or 33% loss
2) Purchasing to Hedge a Stock Position
If you purchased the put to hedge a stock position, calculating your return means finding the difference between your total investment—the price of the premium added to the amount you paid for the shares—and what you would receive if you exercised your option. For example, if you purchased 100 ABC shares at Rs.40 each, you invested Rs.4,000. If you purchased one ABC put with a strike price of Rs.35 for Rs.200, or Rs.2 per share, you’ve invested Rs.4,200 total in the transaction. If you exercise the option, you’ll receive Rs.3,500, for a Rs.700 loss on your Rs.4,200 investment.
Rs.4,200 Total investment – Rs.3,500 Receive at exercise
= Rs. 700 Loss
A Rs.700 loss might seem big, but keep in mind that if the price of the stock falls below Rs.35, you would face a potentially significant loss if you didn’t hold the put. By adding Rs.200 to your investment, you’ve guaranteed a selling price of Rs.35, no matter how low the market price drops.
Pay Of Chart
Assume, Nifty is at 16143.40. You buy a put option with a strike price of 16200 at a premium of Rs. 141.50 with an expiry date of October 28, 2020. A put option gives the buyer of the option the right, but not the obligation, to sell the underlying at the strike price. In this example, you can sell Nifty at 16200. When will you do so? You will do so only when Nifty is at a level lower than the strike price. So, if Nifty goes below 16200 at expiry, you will buy Nifty from the market at a lower price and sell at the strike price. If Nifty stays above 16200, you will let the option expire. The maximum loss in this case as well (like in long call position) will be equal to the premium paid; i.e. Rs. 141.50.
What can be the maximum profit? Theoretically, Nifty can fall only till zero. So maximum profit will be when you buy Nifty at zero and sell it at a strike price of 16200. The profit, in this case, will be Rs. 16200, but since you have already paid Rs. 141.5 as premium, your profit will reduce by that much to 16200 – 141.5 = 16058.5.
The breakeven point, in this case, will be equal to strike price – premium (X – P). In our example breakeven point will be equal to 16200 – 141.5 = 16058.5. Thus, when Nifty starts moving below 16058.5, will you start making profits.
The pay-off chart for the long put position is drawn using the below table.
| Nifty at Expiry | Premium Paid | Buy Nifty at | Sell Nifty at | Pay off for Long Put Position |
| A | B | C | D = A + B + C | |
| 15800 | -141.5 | -15800 | 16200 | 258.5 |
| 15850 | -141.5 | -15850 | 16200 | 208.5 |
| 15900 | -141.5 | -15900 | 16200 | 158.5 |
| 15950 | -141.5 | -15950 | 16200 | 108.5 |
| 16000 | -141.5 | -16000 | 16200 | 58.5 |
| 16050 | -141.5 | -16050 | 16200 | 8.5 |
| 16100 | -141.5 | -16100 | 16200 | -41.5 |
| 16150 | -141.5 | -16150 | 16200 | -91.5 |
| 16200 | -141.5 | -16200 | 16200 | -141.5 |
| 16250 | -141.5 | -16250 | 16250 | -141.5 |
| 16300 | -141.5 | -16300 | 16300 | -141.5 |
| 16350 | -141.5 | -16350 | 16350 | -141.5 |
| 16400 | -141.5 | -16400 | 16400 | -141.5 |
