is found by subtracting the premium paid, 2.30, from the strike price, 139.
This is the point at which the position breaks even. If SPY is below $136.70
at expiration, Isabel has a profit. Profits will increase on a tick-for-tick
basis, with downward movements in SPY down to zero. The long put has
limited risk and substantial reward potential.
An alternative for Isabel is to short the ETF at the current price of
$140.35. But a short position in the underlying may not be as attractive to
her as a long put. The margin requirements for short stock are significantly
higher than for a long put. Put buyers must post only the premium of the put
—that is the most that can be lost, after all.
The margin requirement for short stock reflects unlimited loss potential.
Margin requirements aside, risk is a very real consideration for a trader
deciding between shorting stock and buying a put. If the trader expects high
volatility, he or she may be more inclined to limit upside risk while
leveraging downside profit potential by buying a put. In general, traders buy
options when they expect volatility to increase and sell them when they
expect volatility to decrease. This will be a common theme throughout this
book.
Consider a protective put example:
This is an example of a situation in which volatility is expected to
increase.
Own 100 shares SPY at 140.35
Buy 1 SPY May139 put at 2.30
Although Isabel bought a put because she was bearish on the Spiders, a
different trader, Kathleen, may buy a put for a different reason—she’s
bullish but concerned about increasing volatility. In this example, Kathleen
has owned 100 shares of Spiders for some time. SPY is currently at
$140.35. She is bullish on the market but has concerns about volatility over
the next two or three months. She wants to protect her investment. Kathleen
buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and
the put at the same time, as a spread, the position would be called a married
put.)
Kathleen is buying the right to sell the shares she owns at $139.
Effectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk
profile of this new position.