A put option is the right to sell the underlying futures contract at a certain price.
When traders sell a futures contract they profit when the market moves lower. A put option has a similar profit potential to a short future. When prices move downward the put owner can exercise the option to sell the futures contract at the original strike price. This is when the put will have the same profit potential as the underlying futures.
However, when prices move up you are not obligated to sell the future at the strike price, which is now lower than the futures price because that would create an immediate loss.
Why would any trader short a future instead of buying a put?
The potential to profit on a put option does not come without a cost. The “seller” or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a put option pays a premium to the seller of a put option.
As a result of the added cost of the premium, the profit potential for a put is less than the profit potential of a futures contract by the amount of premium paid. The price of the futures contract must fall enough to cover the original premium for the trade to be profitable.
The breakeven point for a put is where the profit on the futures contract that you can purchase at the strike price is equal to the premium paid for the call.
For every long put option buyer, there is a corresponding put option “writer” or seller. If you have written the put option, then you receive the premium in return for the accepting the risk that you may need to buy a futures contract at a higher price than the current market price for that future.
While Put option sellers don’t have unlimited risk, the risk of writing puts can still be very large. The most a put option seller can lose is the full strike price minus the premium received. If you sell a 100 put option, and the underlying future drops to 20. You will have an 80pt loss minus the premium you took in which will only offset a small portion of the loss. In reality, most futures contracts don’t lose 80 percent of their value as in the example above, but losses on ANY short option can be substantial…so do your homework and fully understand the risks.
Put sellers will profit as long as the futures price does not fall beyond the value of the premium received subtracted from the strike price. For example, if you sell a 100 put strike and receive a premium of 6.00 pts. You will profit as long as the future is above 94 (strike minus the put premium).
The breakeven point is exactly the same for the put seller as it is for the put buyer.
Put options are the right to sell the underlying futures contract. Buyers of the put have some protection against adverse price movements in that they have limited risk (only the premium paid is at risk). On the other hand, hedgers can also use puts to protect against a declining price. Sellers of put options collect premium and accept the risk they may have the underlying “put” into their account resulting in a long futures position, a position that might be at a price much higher than is currently trading in the market.
Using our put selling example, if you sold the 100 put and the price of the underlying declined to 80 at expiration. If the buyer exercised his option, you would be assigned and have the futures put to you at 100 despite the fact it was trading fully 20 points lower in the market. While buyers have limited risk when buying puts and calls, the seller has substantial and virtually unlimited risk.
Peter Knight Advisor