Question

Consider you hold 5000 shares of BHP and at the same time have gone long on put options on BHP. What is the payoff on the expiry date of the option, if (a) the stock price is below the exercise price? (b) the stock price is above the exercise price?     

Answer 1

Answer: Put option- It is a derivative option that is bought when investor is bearish towards a particular security. When price of the security goes down, investor gains profit. It is a right but not the obligation to sell an underlying.

In this question, I bought the Put option because I want to keep my downside safe. I am already holding shares and bought Put, I have to pay premium (upfront) to buy the Put option. Maximum loss is limited to the premium paid and maximum profit is unlimited.

If stock price is below strike price then Put premium will go up and I will get profit in Put position, my upside is unlimited.

If stock price is above strike then Put premium will come down and I will suffer a loss that is limited to the premium paid.

Example: BHP share is trading at $100, I bought BHP Put option of 95 strike @ $3/contract. If spot price come down to $90, I will get profit of:

Profit: Strike-Spot-premium

Profit: 95-90-3 = $2/contract.

Maximum loss if strike price is below spot price = $3/contract (premium).