Who Should Consider Buying SPX Puts?
- An investor who is very bearish on the Standard & Poor’s 500 Index and wants to profit from a decline in its level
- An investor who wants diversify a portfolio with downside exposure of the S&P 500, but may not be willing (or able) to commit the large amount of cash (margin) required for a short position in shares of multiple component issues (or the unlimited upside risk)
- An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk
Buying an SPX put is one of the simplest and most popular bearish strategies used by investors employing SPX index options. It allows an investor the opportunity to profit from a downward move in the level of the SPX, 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 either the unlimited upside risk or margin calls with increasing SPX levels as an investor with short stock positions would be.
Buying an SPX index put gives the owner the right, but not the obligation, to sell the value of the underlying index at the stated exercise (strike) price upon exercise. If the contract is exercised, the put owner will receive its cash settlement amount: the difference between the put’s strike price and the SPX exercise settlement value, times the $100 contract multiplier. Although European-style SPX index options may generally be exercised only on the last business day before expiration, the day on which the SPX exercise settlement value is reported, any long SPX option (call or put) may be sold in the marketplace on or before its last trading day if it has market value.
This is a bearish strategy because the value of the put tends to increase as the level of the SPX index declines, and this gain in option value will increasingly reflect a decline in the level of the SPX when its level moves below the option’s strike price.
The profit potential for a long SPX put is significant as the level of the SPX 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 SPX 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 SPX 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 SPX put strategy while decreasing volatility has a negative effect. Time decay has a negative effect.