Put-ting an End to The Madness Part 2

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Investing

Ciaran Rogers | April 25

Editor's Note: Options are a notoriously complex asset class. This post is the second of a series aimed at ending that confusion. To read the first post, click here.

After understanding the intent of buying and selling a put, the next step is understanding the effect the transaction has on the value of a portfolio.

What Could Happen When Investors Buy and Sell Puts
The Scenario:

Using our scenario from Part 1, we have the following options contract between Janice and Jake, and are assuming that both Janice and Jake each own 100 shares of ABC and that the value of the stock is $5.00 at the time of their contract.

Seller Agreed Upon Date Agreed Upon Price of ABC (Per Share) Number of Shares Buyer
Janice May 1 $5.00 100 Jake
Janice sells this option to Jake for : $1.00

In the example above, Janice agrees to buy 100 shares of ABC stock from Jake on May 1 for $5.00 per share. Jake will pay Janet $1.00 for this right.

If ABC stock price doubles:
Janice (Seller of Put) Jake (Buyer of Put)
Emotional State: Happy Somewhat happy
Profit and Loss: + price of ABC stock and +$1.00 for selling the option to Jake + price of ABC stock but -$1.00 for the price of the option bought from Janice
Explanation: Janice is happy because Jake is not going to ask her to buy his stock and she has successfully made $1.00. Jake is not going to sell the $10 stock to Janice for $5.00 so on May 1, the contract becomes invalid and he loses $1.00. He is happy, though that the stock doubled.

If ABC stock price stays flat:
Janice (Seller of Put) Jake (Buyer of Put)
Emotional State: Happy Mixed Emotions
Profit and Loss: +$1.00 -$1.00
Explanation: Janice is happy because Jake is not going to ask her to buy his stock and she has successfully made $1.00. Jake is not going to sell a $5.00 stock to Janice for $5.00 so on May 1, the contract becomes invalid and he loses $1.00.

If ABC stock price goes to 0:
Janice (Seller of Put) Jake (Buyer of Put)
Emotional State: Sadness Relief
Profit and Loss: - price of ABC stock, -$499.00 -$1.00
Explanation: On May 1, Janice is required to purchase the now worthless stock from Jake for $500. On May 1, Jake will sell the now worthless stock to Janice for $500.00. He’s still out the $1.00 to buy the put option, but could have been out a lot more.

Cost Benefit of Complexity

Even at the most basic level options are difficult to manage. The complexity of the transaction brings on a range of headaches, and has the potential to deal large losses. However, as evidenced in the final scenario, buying puts can be incredibly effective at preserving capital when on the right side of the transaction at the right time. That, in essence, is why we created StratiFi. We want to bring the superior risk management provided by options, but take away all the headaches from buying, selling and managing options in the market.

If you think it might make sense to use options to help preserve your clients’ portfolio, please visit here to schedule a demo.

To learn more about the truth behind asset correlations and volatility, click here for our complimentary eBook "The Five Myths that Put Portfolios at Risk: Revealing the truth and improving investment outcomes using options."

To see how StratiFi’s customized option overlay strategies can protect portfolios, visit stratifi.com/demo and request a demonstration today.