| Know-How |
Put options are not structured products per se, but one of the basic element with which structured products are built. The buyer of a put option has the right (but not the obligation) to sell an underlying asset (a stock, a commodity or any other asset) at a predetermined price.
The seller of a put option has the obligation to buy an underlying at a predetermined price. The buyer pays a premium to acquire the right to sell, and the seller receives the premium. The height of the premium is fixed according to the strike (if it's higher than the spot (in-the-money), then it's more expensive than if it was lower than the spot (out-of-the-money)), the time to maturity (the longer the more expensive), the volatility (the higher, the more expensive). Put options provide leverage, and are usually used to hedge an underlying against price depreciation. Depending on the option's strike, for a 1% rise or fall in the underlying asset's price, the put option will rise or fall by a multiple. Put options expire either in-the-money, in which case they will be worth Strike - Spot, or out-of-the-money, in which case they will be worth zero. Put options are therefore highly speculative instruments.
Long (left) and short (right) put option payoff
The buyer cannot loose more than he invested, whereas the seller's profit is limited to the cashed-in premium, but its loss potential is quasi-unlimited. Buyers profit when the underlying asset's value falls, while sellers loose. The breakeven for a buyer is reached, when the price of the underlying falls by the cost of the premium.
Note that the payoff diagram of a short put option (above, right hand side) is identical to a reverse convertible.
Do's
- Buy put options when your scenario for the underlying is strongly negative and volatility expected to rise.
- Carefully check the time to maturity: if your scenario realizes after the option expires, it will be worthless to you.
- Buy puts when the volatility of the underlying is low and / or you expect it to rise. The volatility in stocks tends to rise when prices fall, therefore the buyer of puts is rewarded additionally.
- Watch the liquidity of your put: it is not unusual to see large spreads in illiquid assets. If necessary, work with limits.
- Check the market often. Put options are usually very time-sensitive, and good timing is essential to enter and exit.
Don'ts
- Never, ever sell put options, if you have not the financial strength to support a loss which can rise to a multiple of the money you have invested.
- Don't buy or sell a put before you have clearly evaluated the risk.
- Don't overinvest. Puts are speculative and you must be ready to loose all (or more if you go short) the money you invested.
- Watch the skew (especially in stocks); don't buy puts where the volatility (and therefore the breakeven level) is too high compared with the strike. In stocks, the volatility usually rises with the out-of the moneyness.
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