When trading put options, is your total risk decreased if you are in a position to exercise the option?

Question

I've been trying to work this out for a while:

Say I own stock X right now trading at $250.

If I were to buy a put option on stock X and I pay $5 for the option to sell at $250,

If the stock ends up worth $300, I sell the stock for $300, made $50 profit, minus $5 for the option, leaving $45.

if the stock ends up worth $200 I sell it for $250, and ended up saving myself from $45 of losses because of the option I bought.

Now same scenario except I don't own the stock, I just buy options because what's life without a little risk.

If the stock goes to the $300 point my option is worthless and I lose $5.

If the stock goes to $200 I sell the option for $50 (maybe a little less) and it's $45 profit.

Would it then be correct to say that buying put options is "less risky" to someone who owns the stock for which they are buying options, in terms of absolute (as in not percent) losses and gains?

Answer 1

The risk situation of the put option is the same whether you own the stock or not. You risk $5 and stand to gain 0 to $250 in the period before expiration (say $50 if the stock reaches $200 and you sell).

Holding the stock or not changes nothing about that. What is different is the consideration as to whether or not to buy a put when you own the stock. Without an option, you are holding a $250 asset (the stock), and risking that money. Should you sell and miss opportunity for say $300? Or hold and risk loss of say $50 of your $250? So you have $250 at risk, but can lock in a sale price of $245 for say a month by buying a put, giving you opportunity for the $300 price in that month. You're turning a risk of losing $250 (or maybe only $50 more realistically) into a risk of losing only $5 (versus the price your stock would get today).

Answer 2

In absolute terms the risk is about the same. If you own the stock and your put option goes in the money, then you have the option to get rid of your stock at yesterday's higher price. If you don't, you can sell the option for a higher price than you paid for it.

But, as you calculated yourself, the net gain or loss (in absolute terms, not percentage terms) is the same either way.

Answer 3

You should also consider what the cost of the Put is, especially if the strike price is set at the current price, vs the average price delta of the security during the period between when you buy the put, and the expiration date. Also note the prices for puts on stocks with a lot of price volatility.

There are a good number of situations where you may come out behind.

If the stock stays the same price, you are out the premium you paid for the put. If the stock price rises less than the premium, you are out the difference between the two. If the stock price falls less than the premium, you are out the difference between the two.

In order to be 'in the money' when writing a protective put, the stock has to either rise more than the premium you paid for the put (and you MUST sell, or hold and write off the expense of the put) or the stock price has to fall below the strike price to a level lower than the premium you paid, and you must SELL via the exercising the option. and you've protected yourself from a loss (presuming you were going to sell and not hold and see if the stock recovers. And since selling is required in both cases, if you've held the stock less than a year, then pay on any profits at short term rates (taxed as regular income) and if the price went down, you can't claim any loss (unless strike price was below your buy price), and would still need to pay if you had a net gain, and you likely can't deduct the price you paid for the put.

Answer 4

There are 6 basic synthetic positions relating to combinations of put options, call options and their underlying stock in accordance to the synthetic triangle. One of them is:

• Synthetic Long Call = Long Stock + Long Put

This means that if you buy the stock and you buy a protective put, you have the equivalent of a long call. You can see this for yourself if we look at a simplified example where there are no dividends, no carry cost and the stock is at the strike price.

Stock = $250 $250 call = $5 $250 put = $5

If you buy an XYZ $250 call for $5, at any expiration stock price, the P&L will be identical to just buying the call.

So then the correct thing to say is that buying put protected long stock is "less risky" than just owning the stock.