Option Strategy: Paired Put

An investor who buys a put option and simultaneously buys a corresponding amount of the underlying stock forms a “paired put” position. This hedging strategy gets its name from an old IRS rule.

When to use?

Investors who use the paired put option strategy want to have the benefits of stock ownership (dividends, voting rights, etc.), but are concerned about the unknown short-term market downside risk. Buying a put option while buying the underlying stock is a one-way bullish strategy. The basic motivation of this investor is to protect the underlying security from falling market prices. He usually buys a certain number of put option contracts corresponding to the number of shares he owns.

benefit?

The investor who uses the paired put strategy retains all the benefits of stock ownership. During the life of the put, he has “insured” his stock against an excessive decline in value. His lower market risk is limited and predetermined. The premium paid for the put is equivalent to the premium paid for the insurance policy. During the life of the option, no matter how much the price of the underlying stock falls, the investor’s selling price of the stock is guaranteed to be at the put’s strike price. If there is a sudden and large drop in the market price of the underlying stock, the put owner has time to react. Another way to achieve the same goal is to pre-set a stop-loss limit order on the purchased stock. But the time and price that trigger this order may not be acceptable to the investor. The put contract gives him a guaranteed selling price and when to sell his stock.

Risks and benefits?

Maximum profit: Unlimited

Maximum loss: Purchase price of limited shares – Strike price + Premium paid

Cap profit at expiration: Price gain of underlying stock – premium paid

The maximum profit depends only on the possible increase in the price of the underlying security. In theory, this increase is unlimited. When the put option expires, if the underlying stock remains at the initial price when the stock was purchased, the investor’s loss is the entire premium paid for the put option.

Break-even point?

Break-even point: Stock purchase price + premium paid

Volatility?

If volatility increases: positive effect If volatility decreases: negative effect

The impact of volatility on the total premium of an option is the time value component.

Time weakening?

The Passage of Time: Negative Effects

The time value portion of the option premium that the option holder “purchases” when buying the option generally decreases, or weakens, over time. This decrease accelerates as the option contract approaches expiration. Market observers will notice that put options time-weaken at a slower rate than call options.

What are the other options before the expiration date?

An investor using the paired put strategy can sell his stock at any time and can choose to sell his long put option before it expires. If the investor is no longer concerned about the possible decline in the market value of the underlying stock he is hedged against, and his put option still has market value, he can sell the put option.

What are the other options at the expiry date?

If the put option is worthless at expiration, no action is required. The investor will continue to hold his stock. If the option goes into the money, the investor can exercise his right to sell the underlying stock at the put option’s strike price. Alternatively, if the option has market value, the investor can sell the put option before the market closes on the option’s last trading day. The premium received from selling the long option can offset the loss caused by a decline in the underlying stock price.