Understanding Buying Puts in Excel

Buying puts is a type of option strategy that allows you to profit from a decline in the price of an underlying asset, such as a stock or an ETF. When you buy a put option, you pay a premium to the seller of the option, and in exchange, you get the right to sell the underlying asset at a fixed price (called the strike price) before a certain date (called the expiration date). You are not obligated to sell the underlying asset, but you can choose to do so if the underlying asset’s price is lower than the strike price.

The main advantage of buying puts is that you can protect your existing portfolio from a drop in the market, or speculate on a bearish move in the underlying asset. For example, if you own 100 shares of a stock that trades at $50, and you buy one put option that gives you the right to sell 100 shares at $50, you have created a protective put. This means that if the stock price falls below $50, you can exercise your option and sell the shares at $50, limiting your loss. On the other hand, if you do not own the underlying stock and buy a put option, you are betting that the stock price will fall below the strike price, and you can make a profit by selling the option at a higher price than you bought it.

The main disadvantage of buying puts is that you can lose the entire premium you paid if the underlying asset’s price does not fall below the strike price before the expiration date. This means that buying puts is a risky strategy that requires a high degree of accuracy in predicting the direction and timing of the price movement. Also, buying puts involves paying commissions and fees, which can reduce your profit or increase your loss.

Basic Theory:

A put option is a financial contract that gives the holder the right (but not the obligation) to sell a specified quantity of an underlying asset at a predetermined price (strike price) within a specified period (until expiration). Buying a put option is a bearish strategy, as it allows the investor to profit from a decline in the price of the underlying asset.

Procedures:

1. Identify the Underlying Asset: Choose the stock or asset for which you want to buy a put option.
2. Determine Strike Price and Expiration Date: Select a strike price and expiration date for the put option based on your market analysis and risk tolerance.
3. Buy the Put Option: Execute the trade to purchase the put option through your brokerage platform.
4. Monitor the Market: Keep track of the underlying asset’s price movements and market conditions.

Comprehensive Explanation:

Let’s consider a scenario where an investor believes that the stock of XYZ Corporation, currently trading at $100 per share, is likely to decline in the next three months. The investor decides to buy a put option with a strike price of $90 and an expiration date in three months.

Scenario:

• Current Stock Price (XYZ): $100 per share
• Put Option Strike Price: $90
• Put Option Premium: $5 per share
• Number of Contracts: 2

Calculation:

1. Total Cost of Put Options:

      

      

2. Breakeven Price:

      

      

   This means the stock price must drop to $85 for the investor to break even.

Excel Table:

Result:

If the stock price drops below $85, the investor will start to make a profit. Conversely, if the stock price remains above $85, the investor’s losses are limited to the initial investment of $1,000.

Other Approaches:

1. Adjusting Strike Price and Expiration: Consider different strike prices and expiration dates based on market conditions and your outlook.
2. Using Greeks for Risk Management: Utilize options Greeks (Delta, Gamma, Theta, and Vega) to assess and manage the risk associated with the option position.
3. Combining with Other Strategies: Explore combining buying puts with other strategies like covered calls to create more complex but diversified positions.