Index Option Strategies - Buying Index Puts in Anticipation of a Market Correction

The Index Strategy Workshop is designed to assist individuals in learning about various index option strategies. These discussions and materials are for educational purposes only and are not intended to provide investment advice. For the sake of simplicity, taxes, commissions and other trading costs have been omitted from the discussions and strategies. These should be taken into account when making investment decisions. These strategies are based on hypothetical situations involving a European-style, cash-settled index and should only be considered as examples of potential trading approaches.

Investment decisions should not be made based upon worksheet outcomes.

Access to, or delivery of a copy of, the Options Disclosure Document must accompany this worksheet.

Who Should Consider Buying Index Puts?

  • An investor who is very bearish on a particular broad market or industry sector index and wants to profit from a decline in its level.
  • An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.
  • An investor who anticipates a decline in the value of a particular index but does not want the unlimited upside risk or the commitment of capital needed for a short sale of underlying shares.

Buying an index put is one of the simplest and most popular bearish strategies used by investors employing index options. It allows an investor the opportunity to profit from a downward move in the price of the underlying index, while committing less capital compared to the potentially significant margin requirements needed for a short sale of numerous component issues. In addition, a long put holder is not subject to margin calls with increasing underlying index prices as is an investor with short stock positions.

Definition

Buying an index put gives the owner the right, but not the obligation, to sell upon exercise the value of the underlying index at the stated exercise (strike) price before the option expires. American-style index options may be exercised at any time before the contracts expire. European-style index options may be exercised only within a specific period of time, generally on the last business day before expiration. However, any long index option may be sold in the marketplace on or before its last trading day if it has market value. All index options are cash-settled. For contract specifications for various index option classes, please visit the Index Options Product Specification area here.

This is a bearish strategy because the value of the put tends to increase as the level of the underlying index declines, and this gain in option value will increasingly reflect a decline in the level of the underlying index when its level moves below the option’s strike price.

The profit potential is significant as the level of the underlying index continues to decline, and is limited only by a potential decrease in that level to no less than zero. The financial risk is limited to the total premium paid for the option, no matter how high the underlying index increases. Many investors find this limited risk more attractive than the unlimited upside risk incurred from a short sale of component stocks. In addition, a short seller of shares must pay any dividends distributed to shareholders while the short position is held; a put holder does not. The break-even point is an underlying index level equal to the put’s strike price minus the premium paid for the contract. As with any long option, an increase in volatility has a positive financial effect on the long put strategy while decreasing volatility has a negative effect. Time decay has a negative effect.

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