Put Option Trading

⚖ Active trading
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Hello you very amazing and knowledgeable people. I hope you are doing well.

I have been researching into Put Options i know these benefit from the fall in share prices. Does anyone kindly know how they are set please as an example? Can any kind of stop losses or anything be used please to minimise losses, like for instance when swing trading? I would be really grateful if anyone could help with advice on this.

Thank you very much for your time and any input you can give. Sending you lots of good wishes.

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Stop losses, especially in the derivative market, may give you a false sense of safety.

Few months ago a friends of mine was autopilot selling straddles (selling both a call and a put at a close strike / same maturity, where you benefit from the asset not moving too much), with stop losses to minimise loss on big movements.

The underlying jumped a 100% on a news; one of his legs went down some 35k€, and no trigger of a stop loss. How come? Well, nobody in the market is willing to sell you a contract where they are guaranteed a 35k loss.

If he had been trading the stock, his stop loss would have went through in the order book during the jump; but not in the derivative market.

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More to the point;

If you are buying options (call or put), your maximum loss will be the premium you pay, if and when the option expires worthless.
Unless you voluntarily exercise a losing option, which I don’t recommend. Yes, it is possible, and yes, it happened.

If you are not looking for expiration, and trading said options (buying with the intent of selling the option at a better price before expiration), then you would be interested in setting stop loss.

If you are underwriting options (ie. selling), you are loading yourself with the obligation to honor the contract. There, a stop loss might not help you, as it happened for my friend; there may simply not be any market to buy back the contract.

You’d instead want to cover your risk by buying cheaper (further away strike) options (ie. a straddle becoming an iron condor).

In case the market would move against you, your losing leg would be partially offset by the option you bought, giving you a max loss, but eating into your premium profit.

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Thank you very much for your very helpful and knowledgeable response Zergui, i really appreciate the time you took to reply.

I am very sorry to hear your friend lost 35k autopilot selling straddles, i do hope he is trying to stay as positive as possible as that is quite a big loss.

Regarding underwriting options (ie. selling), can you kindly please clarify as an example how you would cover your risk by buying cheaper (further away strike) options please? I understand most things regarding this but as the stop loss may not help in this situation, i please wondered how you set these trades so the losing legal would be offset by the option you bought?

Thank you very much for being so kind and helpful, i truly appreciate it. Hope you are having a good day.

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He is doing fine, but still very sore about that one :joy:

Let’s take a simplified example; you underwrite a call option (so, sell a call option) for a certain security, at let’s say a strike of 100$, and collect a premium for it (that would be your max gain).

If the underlying were to rise above the strike price, you would start to lose from your maximum gain, and the further the price rises, the more negative your position would turn. In this case, the buyer of the option will exercise it, and you are then obligated to sell a 100 shares of the underlying, at the agreed price of 100$.

At this point, it doesn’t matter if you already owned such 100 shares, or if you had the cash to honor the transaction; if the shares are trading at 150$, you either lose 100 shares @150$ = 15.000$ to sell those at 100$ => net loss of 5.000$, or you would have to buy the shares @150 to sell them @100 => same loss of 150$. Owning the shares as a collateral does not yield any benefit against having just cash for collateral instead.

And if the underlying were to rise even more, your maximum loss would be greater and greater. As we saw earlier, having a stop-loss to buy back the same call contract you initially sold in the market might not work; after all, if your contract is worth -5.000$, there may be nobody in the market to take on that liability.

You can hedge that risk by buying yourself a call option, at a higher strike. Say you sell your call option at a strike of 100$ like previously, and collect a premium for it; you may also buy a call option at a strike of 120$, for which you must pay a premium (that will be lower than the one you received). In effect, your maximum gain is lowered, as some of the premium you collect is used to buy a contract, but now you have capped your maximum loss to 20$ per share (- the premium gain). If the underlying were to rise more, you yourself own a call that you can exercise, and get the 100 shares you need to deliver that way.

Your maximum gain would be [Premium Collected] - [Premium spent on the higher strike option]
Your maximum loss would be ([Higher Strike] - [Lower Strike]) * 100 - [Maximum Gain]

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I found this quite informative when learning about options.