Put Options Explained Through Insurance
Now let’s try to draw a parallel with everyday life: put options in everyday life.
Let’s think about a homeowners insurance policy covering the risk of an earthquake. The policy has a premium, which, coincidentally, is called a premium, just like an option premium, and it represents the insurance company’s profit.
The policy has an insured value that is paid out in the event of an adverse event. The insurance company collects the premium and will be required, will be obligated, to fulfill the contract by paying the insured value to the policyholder.
Let’s draw a parallel: the insurance premium is the option premium, the policy expiration date is the option expiration date, the insured value corresponds to the strike price, and the market value of the house is the value of the underlying asset at the time of the transaction.
Let’s see all of this on a chart. It may not be very easy to understand for someone looking at options for the first time. Here we can see the put option and the call option.
In this presentation, we’re mainly interested in the put option because the strategies we’re going to validate primarily use these options.
From the perspective of a put option buyer, a put option provides protection against a decline, a market decline.
How to Read the Payoff of Put Options
How do we read these charts?
The dark green line represents my profit at expiration. The light green line represents my profit or loss as of today. The red line represents my profit or loss at an intermediate point in time.
So let’s assume that this is the price of an underlying asset, a stock. What happens? I buy a put. What happens if, at expiration, which is when the option’s payoff is represented by the thick green line, the underlying asset remains unchanged?
We have a loss. As you can see, on the Y-axis we have the loss in dollars. Here, on the X-axis, we have the value of the underlying asset as it moves: it can rise or fall.
So if the price of the underlying asset remains unchanged, I, as the buyer of an option, lose the entire premium. When will I start making money? When the underlying asset starts falling, falling, falling, falling, and crosses the strike price. That’s at expiration.
But what if it falls immediately? If it falls immediately, I make money immediately.
This is what it looks like for the buyer of a put option.
If we instead put ourselves in the seller’s shoes, it’s the exact opposite, meaning that the seller is in this situation.
The Difference Between Buying and Selling Put Options
If nothing happens, the seller will have earned the premium at expiration. If the market falls slightly, the seller will keep the premium. When will the seller start suffering? When the strike price is crossed and the underlying asset continues to fall.
These other charts show the payoffs of call options. But we’ll cover them less in this discussion, so let’s focus on the put.
A put option therefore gives the buyer the right to sell a financial instrument at a predetermined price, which, as we said, is called the strike price.
Since the selling price has already been predetermined, the buyer will make a guaranteed profit if the price of the underlying asset falls before the expiration date. That’s what we just saw on the chart.
Buying a put option is therefore a bearish trade. Conversely, if I’m the seller of a put option, I can make money if the market isn’t bullish.
This is an important difference. Someone who buys an option needs the market to move in their direction. Someone who sells it, on the other hand, can make money even if nothing happens. They have more ways to profit and a higher probability of making money.
At this point, let’s start talking about strategies.
Naked Put Options Selling: Characteristics and Risks
For an options trader, someone who is familiar with options, what is the oldest strategy in the world? I’m sure many of you already know it: selling naked puts.
Naked means that I sell an option and nothing else, without any additional protection, without buying another option at a lower or higher level. I just sell a single option.
What are the characteristics of this strategy? It profits from the passage of time, and that alone makes it very different from any other type of strategy involving linear instruments. And as we’ve seen, it is a non-bearish strategy.
Here it is. We have the option premium, which represents my profit. And you can see that it’s capped. If I sell an option, the most I can make is the premium. That’s it. I can’t make any more. The stock can do whatever it wants, but I can’t make more than the premium.
However, if the market moves against me and moves very far against me, my risk is potentially unlimited in the case of call options, or very, very large because the stock could potentially go to zero, okay?
So there is an asymmetry between risk and reward.
The Put Seller as an Insurance Company
Now let’s try to explain it in another way. What does selling puts mean? We can compare a put seller to an insurance company.
The company collects a premium every year to insure our car. Let’s use a different example: an auto insurance policy. If an adverse event, meaning an accident, doesn’t occur, the company has no payout and systematically profits from the passage of time by collecting that premium every year.
What does selling puts mean? By selling puts, we have the opportunity to collect a premium on every trade. If the underlying asset doesn’t experience excessive declines, our trading activity becomes similar to a monthly income stream. I say “similar” because, of course, it isn’t actually like that.
That’s what people who promote this type of strategy often say on the Internet: they mistake the premium that is always collected for some kind of income stream. But in reality, we’ve seen that the market can move against us at certain times.
There is an asymmetry: the premium is guaranteed, but the risk can be much greater.
So, when dealing with equity options, selling put options consists of collecting a premium. If the underlying asset doesn’t fall below the strike price, the trade ends with a profit equal to the premium collected.
Share Assignment and the Microsoft Example
If, on the other hand, the stock price falls below our strike price, we will be required to buy the shares at the strike price, which is the insured value.
Let’s assume I have a stock worth 10, okay? I sell a put on that stock at 7. The stock falls to 5, and I buy it at 7. I’m obligated to do so.
I acted as the insurer. I guaranteed another person that I would buy it at 7, but the stock falls to 5, and if I want to liquidate it on the market, I have to sell it at 5. That’s where my loss comes from. I still keep the premium that has already been paid to me.
The buyer of the put we sold will exercise their right only if it’s in their best interest, in some cases even before expiration.
When equity options are “American-style,” as they’re called, they can also be exercised before expiration. Their right is to sell the shares to us at the strike price. We will therefore end up holding their shares in our portfolio.
This is an example of a strategy that involves selling a put on Microsoft with a strike price of 300 and an expiration date of December 18, 2026.
You can see 300. This is the price level. From this point onward, the premium starts to erode, and the seller of this put starts losing money.
If nothing happens between now and December, the seller collects $1,000.
And the seller collects it even if the market doesn’t fall by more than 25%. This screenshot was taken a few months ago. But let’s say that the market priced this insurance at $1,000.
In other words, insuring Microsoft, as of that date, against falling below $300 by December paid $1,000.
