How do traders combine a short put with other positions to hedge?

A trader can use put options in a variety of ways, depending on the positions he is hedging and the option strategies he is using to hedge. A put option contract for equity shares gives the holder (buyer) the right, but not the obligation, to sell 100 shares of the underlying stock at the exercise price before the offer expires. Conversely, a trader may sell a put to capture the premium on its own or as part of a larger options strategy.

Understanding Hedging with Short Put Options

Investors use hedging strategies reduce the risk of your investment portfolio or specific position. Hedging essentially protects against adverse price movements relative to an underlying position, stock, or portfolio. The purpose of hedging is to reduce risk and limit or eliminate the possibility of loss.

While options strategies are often used by investors to generate profit and income, they are also often used to protect an investment position, such as owning a stock.

Bought put option

A purchased put option (long) gives the investor the right, but not the obligation, to sell the security at a predetermined exercise price of the option on or before expiration. For example, let’s say an investor bought shares at $100 and wanted to protect against any losses.

An investor decides to buy a put option with a strike price of $90, which will pay when the stock price falls below $90. However, the investor paid a premium for the option, and that upfront cost was $2, meaning the put option wouldn’t make any money until the stock price fell below $88 per share. In other words, above $88, the put option will make a profit to offset any losses in the stock position.

The stock price at expiration was $85.

If the stock price rises to $85, an investor could sell 100 shares at $85 in the market and lose $15 ($100-$85). However, the investor will exercise the put option and earn the difference between the strike price of $90 and the market price of $85. Taking into account the $2 premium, the option trade will generate a profit of $3 ($90 strike – $85 market price – $2 premium).

The $3 profit on the put option will partially offset the $15 loss on the long stock position and limit the loss to $12 per share.

The stock price at expiration was $110.

If the stock were worth $110 at expiration, the option would not be exercised and would expire worthless. The reason it expires worthless is because the investor would not exercise the call option on the stock at a strike price of $90 when the stock could be sold in the market for $110 per share. However, the investor will lose a premium of $2, which is the maximum amount of loss when trading options. Assuming the investor sold the position at $110, the profit would be $8 or ($110 – $100 purchase price – $2 premium).

Sold put option

Instead of exercising the right to sell the stock at $90, the investor can sell the put option to someone else to close out the position. The investor will then receive a premium that offsets the premium he paid to open the original position. Since they will be giving up the right to exercise the option, they can either sell the shares on the open market or decide to hold onto them in hopes that they will recover.

For the option writer taking the position, this means that someone else has the right to exercise the option against the seller and “put” their long position on the option seller at the exercise price. In other words, although the option writer will receive the upfront premium, he may be forced to buy the shares at the exercise price if and when the option is exercised. Using the previous example, assume that an investor sold a $90 strike put and received a $2 selling premium. Where the stock closes at expiration will determine whether the trade is a profit or a loss.

The stock price at expiration was $85.

If the stock price was $85, it would be exercised and the investor would have to buy the shares at the $90 exercise price. In other words, a put option buyer, who supposedly had a long position where they bought the shares at $100 would want to sell their shares at the $90 strike (limiting their losses) since the market price was $85. The buyer of the put option forces the seller of the put option to buy the stock at $90 per share.

Assuming the investor immediately sells the stock upon exercise of the put option, the loss would be $5 ($90 strike – $85 market price). A $2 premium paid up front to the option writer will help mitigate the loss, reducing it to $3 ($5 loss – $2 premium earned).

The stock price at expiration was $110.

If the stock were worth $110 at expiration, the option would not be exercised and would expire worthless. The reason it expires worthless is because no investor will exercise the option to sell their shares at $90 when they can sell them on the open market at $110 per share. However, the seller of the option will receive a premium of $2, the maximum amount that can be earned on the trade.

Worst case scenario

The worst case scenario for the option writer is that he is exercised and forced to buy the stock and the stock price goes to zero. Using the previous example, an investor who sold a put at the $90 strike would lose $90, but with the $2 premium received, the net loss would be $88. Since one option is equal to 100 shares, the investor would have lost $8,800.

Vertical put spread

Options strategies, called spreads, help reduce the risk of loss for options sellers by limiting losses on a trade. A trader can hedge a long position in a stock or other asset using vertical put spread. This strategy involves buying a put option with a higher strike price and then selling a put option with a lower strike price. However, both options have the same expiration date. A put option spread provides protection between the strike prices of purchased and sold put options. If the price falls below the strike price of the put options sold, the spread does not provide any additional protection. This strategy provides a window of fall protection.

Let’s say an investor bought a stock at $92 and wanted to protect against a decline. However, buying a put option with a strike price of $90 costs $4, which is too expensive for an investor. The investor decides to sell the put at a lower strike price to offset the cost. Below is what the options strategy would look like:

• A put option with a strike price of $90 (bought option) with a premium of $4.
• A put option with a strike price of $75 (the option sold) receives a premium of $3.
• Net premium value of $1.00

The investor is protected if the stock price falls below $90 and remains above $75. However, if the stock price falls below $75, the options strategy no longer provides protection.

The vertical put spread strategy has advantages and disadvantages compared to a purchased put. Typically, a straight put option is quite expensive for many investors. However, purchasing a put option provides the greatest protection for those who are long the underlying stock. Even if the stock price falls to zero, a standalone put option will protect the investor below the strike price.

On the other hand, a vertical spread protects the investor until the sold put option is exercised or a lower-priced option is exercised. Because the protection is limited, it is cheaper than a standalone put option.

Benefits of Selling Put Options as a Hedge

Put options provide downside protection to a long position. Although the protection offered by a vertical spread is limited, it can be quite useful if the stock is expected to have limited downward movement. For example, the stock price of a well-established company may not fluctuate too much, but a put spread can protect the investor within a range.

It is important that investors become familiar with the different types of options before entering into a trade. Many brokers require investors to complete online training courses before an investor can use options hedging strategies.

Investopedia does not provide tax, investment or financial services or advice. The information is presented without regard to the investment objectives, risk tolerance or financial situation of any particular investor and may not be suitable for all investors. Investing involves risk, including possible loss of principal.