Buying Index Puts

[Igor 10]

Traders who buy an index put are betting that the market prices of the index's underlying assets will fall. The strategy involves buying a put that's linked to a stock market index. The underlying index plays the same role as an asset does in options trading. Investors settle all index options in cash, and there are no assignments of assets. The profit potential and risk involved when using this strategy varies. Traders buying index puts limit their losses to only the amount paid in premiums when entering the market. On the contrary, the trader's profit potential is unlimited, since any stock index can theoretically fall up to a zero value.

 

Moneyness Review for Puts

Out-of-The Money (OTM) = Strike Price (less than) Market Price

In-The-Money (ITM) = Strike Price (more than) Market Price

At-The-Money (ATM) Strike Price (equals) Market Price

 

Understanding the Differences Between Index Options and Regular Options

Buying an index option functions the same way as in buying a regular option. The difference is that the underlying assets associated with index options are many compared to just the one underlying asset that's associated with a regular stock option.

 

Example: The S&P500 is worth $4000 and its index option, SPX (Index Option), is valued at $400 (1/100 of the S&P500).

 

 

How to Buy Index Puts (ATM)

 

The S&P500 is worth $4000 (market price) in June.

1) Trader buys an index put option: SPXDec400($4.00)

- One S&P500 index option with a contract multiplier of $100

- Strike Price $400, at-the-money (ATM), expiring in 180 days

- Premium Cost of $4.00

2) Trader pays $400 for the put (100 x $4.00 (premium cost)).

Total cost to enter the market: $400

 

Result one: SPX falls to $380 in December.

a) The put option purchased expires ITM. The trader exercises his or her right to sell 100 shares at $40.

b) The difference between the option's strike price and the SPX is $20 (strike price: $400 - SPX: $380). There is no assignment of assets, so the put seller uses the contract multiplier (CM) to figure the trader's cash settlement.

c) The seller pays the trader $2000 [100 (CM) x $20 (difference in prices)]. Subtracting the $400 credit paid to enter the market reduces the trader's profit to $1600.

 

Result two: SPX rises to $420 in December.

a) The put option purchased expires worthless (OTM), and the trader lets the option expire.

b) The trader loses the premiums paid to enter the market. In this example, the trader's total loss equals $400, which is the maximum loss for this type of trade, independent of how high the market rallies.

 

Advantages and Disadvantages in Buying Index Puts:

 

Pluses: The upside in buying index puts is that traders can control their losses. They pay a premium when entering the market, which is the maximum that they can lose. Another benefit in using this method is that traders can gain unlimited profits for a limited amount of risk.

 

Minuses: The only downside in buying index puts happens when the market rallies and the put option expires worthless. In this case, the trader would lose what he or she paid to enter the market.