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  • Give Me Options - Risk Profiles of Put Options



    Overview of Markets

    US stock market is closed today due to a US holiday, no news. Our assessment on the US market hasn't changed: US market is in a correction and no new long positions should be inititiated due to the increased risk of being stopped out.

    Chinese market: after yesterday's big down, today the Chinese market is up moderately (by Chinese standard) on lower volume. This shows that the big boys are not eager to jump back into the market yet. So, this correction may have more days, weeks, or even months to go. Now the risk is significantly larger than usual, and we do not recommend opening new long positions. In other words, do not buy stocks right now. We wait until the storm is clearly over, then we get into more stocks. If you have positions that are losing, cut losses to reduce exposure. If you have big winning stocks, such as 002107 (if you bought around 25 as we recommended), keep it, or sell just part of it (but keep the bulk of your big winning positions in case they can go a lot higher).

    The Shanghai Composite is up moderately today on lower volume after yesterday's big sell-off


    Hong Kong market: nothing new, there are no immediately buyable stocks accoridng to our systems.


    In the previous article, we introduced the risk profiles of long and short the underlying instrument (e.g., stocks or futures contracts). We also talked about the risk profiles of long and short a call option. In the preseent article, we discuss the risk profiles of long and short a put option.

    Recall that an option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date.

    A put option is like an insurance policy

    To best understand a put option, let's make an analogy:

    When you buy a new car, you also want to (or required to) buy a car insurance. When you buy a car insurance, it is like you have bought a put option on the car. This means that if anything happens to the car, the put option will be exercised. If not, the insurance company gets to keep the premium you paid.

    Say I have a car worth $25,000, I go to an insurance company and I buy an insurance on my car. I pay a premium of say $1000 to insure the car at $25,000, with an expiration of a year. It is the same as an option, there is a strike price ($25,000), a premium ($1,000) and an expiry date (a year). Let’s say I smashed the car into the wall, I will exercise the claim and receive my $25,000. By paying only $1,000 for the “put option”, I now received $24,000 in "profits". An insurance company actually sells put options.

    If a 16-year-old wants to buy a corvette, who has no track record or driving experience, his “put option” is going to cost a lot. Whereas a 50-year-old man, who has a perfect driving record will have a relatively lower “put option”. Hence, the volatility, the chance of you smashing into the wall, your history, is going to determine the price of your put option. Likewise, a stock that have high volatility will command a higher option premium because there is a higher probability of the stock reaching the strike price.

    Risk Profile Charts for Put Options

    Now that you understand what a put option is and you know what long and short calls look like, let’s look at the risk profile of a put option.

    Long put option risk profile (limited downside, and almost unlimited upside)




    Short put option risk profile (almost limited downside, and limited upside)



    Conclusions:

    Buying a put (long put)
    1. Buying a put option gives you the right, not the obligation, to sell an
      underlying instrument (that is, a share).
    2. When you buy a put option, you are not obligated to sell the underlying instrument—you simply have the right to do so at the fixed (exercise or strike) price.
    3. Your risk, when you buy an option, is simply the price you paid for it.
    4. Your reward is potentially unlimited. With long puts your reward is
      unlimited to the downside, for example, the exercise price less the price you paid for the put itself. In this example that is: $80 − $5.58 = $74.42.

    Selling a put (short put)
    1. Selling a put option obliges you to buy the underlying asset to the option buyer. Remember, when you sell a put, you have sold the right to sell to the person who bought that put.
    2. Selling options naked (for example, when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile. The continuous downward line is generally not a good sign because it means unlimited potential risk.
    3. Combined with the fact that you are obliged to do something, this is generally not a preferable position in which to put yourself.

    Regarding calls and puts, there are four charts you need to remember. Even if you just remember the long call option risk profile, you should now be able to construct the other three basic option positions. When you are comfortable with these and the logic behind them, you’ll be ready to look at spreads and combinations with ease.

    The Four Basic Risk Profiles for Options








    So, from the previous article and this article, you should have learned the following essential P/L characteristics of long/short stock/call/put:






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