For those who are very bearish on the SPX index over the near- or long-term, and who require a known, limited upside risk, buying a put might be an appropriate strategy to use. Purchasing an SPX put option requires a smaller initial cash investment than the margin requirement for a short sale of multiple shares of component stocks. In addition, there are no margin calls, nor does a put holder pay any dividends. This reduces the capital at risk and offers the potential of leveraged profits if a bearish SPX outlook proves correct. As the SPX index level continues to decrease, the long SPX put’s profit potential is limited only by the index declining to no less than zero, and large returns on investment can be seen. On the upside, the investor with short stock positions is exposed to a potentially unlimited dollar loss from an increase in share value, while the SPX put buyer’s maximum loss is known in advance and is limited entirely to the option’s purchase price.
Selling vs. Exercising Expiring SPX Options
Remember that SPX options have European-style exercise and A.M settlement characteristics. An investor with a long call or put position may sell that position, if it has market value, on any day up to and including the business day (usually a Thursday) preceding the day on which the exercise settlement value is calculated. However, the option contract(s) may be exercised only on the day the SPX exercise settlement value is calculated and disseminated, or the last business day (usually a Friday) before the expiration date.
In other words, an investor with an expiring long SPX put may observe current market prices during its last trading day (Thursday) and have the opportunity to sell it before the market closes. If on that day the investor considers exercising the put instead, he will be exposed to a degree of overnight market risk. This is because the cash settlement amount received upon exercise will not be known until the following morning (Friday) when the market opens (possibly up or down significantly) and the exercise settlement value is calculated. As well, an option that is in-the-money (or out-of-the-money) at the close of the last trading day may or may not be so the next morning when compared to the calculated settlement value.
Option Premium and Exercise Style
Investors may observe that European-style options trade at lower relative value than American-style options with similar contract size. This is because investors may pay more for American-style contracts in exchange for the right of early exercise (before expiration). And because European-style options may be exercised only on a given day before expiration, during their lifetime some in-the-money contracts (notably puts) may commonly be priced and trade below parity, or below their intrinsic value.