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My apologies if this is too simple a question, but there's a (possible) misconception that I wanted to clear. I did search for resources on the web and I think I have understood about 90% of the mechanics involved but there are some aspects that I don't think I have properly understood.

For the rest of this post, I am focusing on the worst-case scenario.

Given my personal circumstances and risk appetite, I don't think I will ever buy shorts since they have an unlimited associated risk. However, for lesser returns (esp. factoring in theta decay), buying puts can serve a functionally similar purpose.

Either owing to faulty advice or my inability to comprehend what was being said during a lunch with my ex-colleagues, I have formed a conception that at expiration puts are converted to shorts. On the contrary, the recent YouTube videos that I have seen and some blog articles that I have read, seem to suggest that puts have limited risk involved. Which of these two things is true (since if puts become shorts the latter represents unlimited risk)?

Consider a worst-case scenario where I am hospitalized for a month (say for COVID-19) and the date of expiration coincides with the mid-point of my stay in the hospital. Is there an action that I have to take to prevent puts from turning into a contract that represents unlimited risk? I don't mind a scenario where a $1000 worth of puts turn worthless at expiration. It's a costly lesson for sure, but it's something that can be lived with. However, I don't want a scenario where after coming out of the hospital I have in my hand a contract that makes me responsible for hundreds of thousands of dollars (the whole point in avoiding shorts in the first place).

For any and all scenarios: Is it true that the risk in buying puts is limited? Is it true that the maximum amount I can lose in puts equal to the amount I spent while buying them?

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For any and all scenarios, it is not true that the risk in buying puts is limited.

When you buy an option to open, you are long that option. When you sell an option to open, you are short that option (opening transactions). You can sell to close a long option or buy to close a short option any time before expiration.

Exercised American style options turn into equity positions (index options can only be exercised at expiration and they are settled in cash). For this discussion, let's assume that no stock is owned and there are no short stock positions.

The owner of a long put has the right to exercise his option and sell the underlying at the strike price. If he does so, he becomes short the stock. The counterparty who is assigned becomes the owner of the stock.

The owner of a long call has the right to exercise his option and buy the stock at the strike price. If he does so, he becomes long the stock. The counterparty who is assigned sells the stock, becoming short the stock.

Only short stock has unlimited risk. With assignment, long stock can lose no more than the strike price less the premium received by the seller.

Traditionally, one could lose no more than the premium paid for a long option. However, about 15 years ago the SEC approved a rule called Exercise by Exception which means that if an option is one cent or more in-the-money (ITM) at expiration, the Option Clearing Corp (OCC) will automatically exercise it whether it is long or short. That means that an exercised long ITM put will become short stock with the aforementioned unlimited risk.

If you are long the option, you can designate to the OCC via your broker that it is not to be auto exercised at expiration. This would make sense if it is ITM by pennies and your commission and/or fees to close the position exceeds the ITM amount. It would also manage the scenario of your hospitalization risk.

I would assume that you could make this designation at any time but you should check with your broker rather than accept my assumption.

Is it true that the maximum amount you can lose in puts equal to the amount you spend while buying them if you request that they not be exercised by exception.

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  • Thanks for the answer (sorry I can't up-vote due to limited rep)! I must admit I didn't understand most of it. Is there a comprehensive resource that covers the terms here in your answer (a YouTube video or a blog post)? Most resources for beginners that I have seen keep on repeating you have the right to sell and other related things. Sure these things are important, but I haven't been able to find the details. Also, is there an easy check-box request that they not be exercised by exception for common online-brokers? The potential to unlimited risk is my primary stumbling block. – borejwaz Sep 30 '20 at 4:51
  • Will a long ITM put be automatically exercised to become a short stock even if I do not have a margin account? – Flux Sep 30 '20 at 12:18
  • @borejwaz - Don't worry about the upvote. The points aren't important. Re comprehensive resource, you're not going to learn much more than the basics online. Pick up a copy of "Options as a Strategic Investment" by Lawrence G. McMillan. Well written with many clear examples. You can get an older edition for $5-$10. No need to spend $75+ for the newest. You can do that if/when your option understanding/needs has progressed to more complex strategies like hedging. I don't know how different brokers handle the do not Exercise by Exception designation. Contact yours. – Bob Baerker Sep 30 '20 at 12:45
  • Will a long ITM put be automatically exercised to become a short stock even if I do not have a margin account? Call your broker. – Bob Baerker Sep 30 '20 at 12:45
  • "For any and all scenarios, it is not true that the risk in buying puts is limited" Counterexample: if you already have 100 shares of the underlying in your account for every 1 ITM put option exercised automatically. – Flux Sep 30 '20 at 17:29
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For a cash-settled index put, you are completely safe.

For an equity put, the risk is that it expires in-the-money and is exercised, leaving you with a short position that can then move against you. To avoid this, before expiration, you must either sell the put or buy the stock. As long as you take action before expiration, your risk is limited.

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  • Mostly will accept this as the answer in a few days, unless I can understand Baerker's answer. Can't upvote due to limited rep. – borejwaz Sep 30 '20 at 4:45
  • "... leaving you with a short position that can then move against you" What happens if I am not using a margin account? Will I be left with a short position even if I do not have a margin account? – Flux Sep 30 '20 at 12:22
  • @borejwaz - It's rather important that you understand my answer before beginning to dabble in options. Why? Because it's your money at risk and betting on a game that you don't understand is a recipe for disaster. – Bob Baerker Sep 30 '20 at 13:05
  • @Flux You well might. The broker may (but is not obligated to) sell your put before expiration to prevent exercise. Or if it is exercised, the broker can then forcibly liquidate your position at any time (including illiquid premarket trading), as you would have broken the rules of a cash account. It is your responsibility to avoid having an option auto-exercised when your account doesn't have the assets or borrowing ability to support it. – nanoman Sep 30 '20 at 13:41

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