Buying Index Puts

Description

Market Outlook: Bearish over the short term.

Goal: Positioning to profit from a decrease in the level of the underlying index.

• You are anticipating a decline in the broad market or market sector measured by the underlying index in the near future. You want to take an aggressive position that can provide a great deal of leverage.  
• You make this decision aware of the possibility that you may lose the entire premium paid for the option.

An index put option provides the purchaser the right to participate in underlying index declines below a predetermined strike price until the option expires. The purchaser of an index put option has substantial profit potential tied to the degree of declines in the underlying index.

Scenario

Assume that XYZ symbolizes an underlying index that interests you and it is currently at a level of 200. You decide to purchase a 6-month XYZ 195 put for a quoted price of $3.90 per contract. Your net cost for this call is $390 ($3.90 x 100 multiplier). You are risking $390 if the underlying index level is not below the strike price of 195 when the XYZ put expires.

The break-even point (BEP) at expiration is an XYZ index level of 191.10 (strike price 195 - premium paid $3.90) because the put will be worth its intrinsic value of $3.90, which is what you originally paid for it. The lower the XYZ index settlement value is below the break-even point at expiration, the greater your profit.

Possible Outcomes at Expiration

1. XYZ index level below the break-even point (191.10):

If at expiration XYZ index has declined to 185, the XYZ 195 put will be worth its intrinsic value of $10 (strike price 195 - settlement value 185). Your net profit in this case would be $610 (settlement amount $1000 received from exercise - net cost of put $390).

2. XYZ index level between strike price (195) and break-even point (191.10):

If at expiration XYZ index has declined to 193, the XYZ 195 put will be worth its intrinsic value of $2.00 (strike price 195 - settlement value 193). You could exercise the option and receive the settlement amount of $200 ($2.00 intrinsic value x 100 multiplier). This amount would be less than the net amount paid for the put ($390), but it would offset some of that cost. The net loss in this case would be $190 (net cost of put $390 - settlement amount $200 received from exercise). This loss represents a little less than half of your initial investment.

3. XYZ index level above strike price (195):

If at expiration XYZ index has advanced to 202, the put would have no value because it is out-of-the-money. You will have lost all of your initial investment, a net of $390. The net premium paid for an index option represents the maximum loss for an option purchaser.

Note: No matter how far XYZ advances above the strike price, the loss will not exceed $390.

Buy XYZ index 195 Put at $3.90 with index at 200 net cost for put = $390
Level of XYZ index at expiration	XYZ index advances to 202 (above strike)	XYZ index declines to 193 (between strike and BEP)	XYZ index declines to 185 (below BEP)
Move in level of index	up 2 pts.	down 7 pts.	down 15 pts.
Value of put at expiration (per contract)	0 (out-of-the-money)	$2	$10
Less premium paid for put	$3.90	$3.90	$3.90
Net profit/loss* (per contract x 100)	–$390	–$190	$610