Participate in a Decreasing Index Level with Limited Upside Risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
Index XYZ is currently at 500. An investor could purchase one three-month XYZ 495 put, which represents the right to sell the underlying index level at a level of 495, for a quoted price of $9. The total cost for the put would be: $9 x 100 contract multiplier = $900. By purchasing the put the investor is saying that by expiration he anticipates index XYZ to have declined below the break-even point: $495 strike price – $9 (the option premium paid), or an XYZ level of 486.
The investor’s profit potential can be significant as the level of index XYZ continues to decline below 486, and is theoretically limited only because an index can decline to no less than zero. The risk for the put purchase is limited entirely to the total premium paid for the contract, or $900, no matter how high the level of index XYZ might increase.
Before expiration, if the put purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain. On the other hand, if the investor’s bearish outlook proves incorrect and XYZ increases, the put might be sold to realize a loss less than the maximum.
Consider three possible scenarios at expiration:
- XYZ closes below the break-even point
- XYZ closes between the strike price and the break-even point
- XYZ closes above the strike price