Question

Currently a stock that sells for $57 has a put option at $55 and another at $60. The prices of the options are $6 and $3, respectively. What would you do? Illustrate and explain your actions.

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Answer 1

A put option is said to be in the money if exercise price is more than the stock price. The more the put is in the money the more costly it will be.

Here,
Put option at $55 is out of the money and put option at $60 is in the money. However price of $55 option is more than, price of $60 option.
Therefore put option at $60 is better than put option at $55.

If there’s an expectation of stock price falling in order to protect against the falling stock price we should but put options at $60.
Premium Outflow = $3

This will protect us against the falling share price. Hence the pay off from put option will set off against the share price falling and meanwhile we will continue to enjoy the upside.

If share price falls below 60
Put option will be exercised and pay off from put option will be = Exercise Price – Share Price
Pay off from Shares = Share Price
Total pay off = Exercise Price

If share price rises above 60
Put option will lapse and pay off from put option will be = 0
Pay off from Shares = Share Price
Total pay off = Share Price

Hence we continue to enjoy the upside and also get protected against the downside.

For instance, lets say

1) Share price falls to 55
Pay off from Put option = E – S = 60 – 55 =$5

Payoff from Shares = S = $55
Total payoff = Pay off from Put option + Payoff from Shares
                       = 5 + 55 = $60

2) Share price rises to 65
Pay off from Put option = 0 as put option will lapse
Payoff from Shares = S = $65
Total payoff = Pay off from Put option + Payoff from Shares
                       = 0 +65 = $65