Options are a very interesting financial instrument that allows investors or speculators to hedge their positions. Thanks to their design, they can be "purchase of insurance" before the market turmoil. 

As already mentioned in the first part of the cycle, options are a type of contract between two parties to a transaction. At the same time, each party has different rights and obligations. For this reason, the profile of potential gains and losses varies. Purchasing a call option allows the owner to buy the underlying instrument at a predetermined price. On the other hand, the purchase of a put option allows you to sell a given underlying instrument at a predetermined price.

The married put strategy

It is an investment strategy of hedging a long position by buying a put option. The benefit of buying a put option is the reduction of losses in the event of a negative scenario (decrease in the value of the underlying). The cost of such a strategy is the premium paid for the put option. As a result, the potential profit is reduced by the amount of the bonus. This is the classic "buy policy" before an adverse market event. Depending on the investor's strategy, a married put may take the following form:

Long position + put ATM option

Put option of type ATM (At-the-money) has an exercise price around the current market price of the underlying. As a result, the buyer of the option undertakes to sell the shares at a price close to the market price. The maximum loss is equal to the premium paid. 

An example is hedging a long position on Amazon stocks. At the end of the trading session on March 5, the value of one share is $ 3. The investor wants to hedge a position (000 shares) by purchasing a put option that expires on June 100, 18. The option exercise price is $ 2021. The option premium is $ 3. With this transaction, the investor hedges against a loss of less than $ 000. However, at the same time, it cuts profits by $ 212,65. The maximum loss on the transaction is 3%. In the case of an increase in the rate, the profit on the transaction will appear only when it rises above $ 000.

Source: own study

Long position + put OTM option

The OTM (out-the-money) put option has an exercise price below the current market price. Due to the fact that the sale price is set below the current market price, the probability of exercising the option is lower than in the case of ATM. As a result, the premium paid is lower than for the ATM option. The "cost" of such a strategy is a much greater potential loss. It is equal to the sum of the premium paid and the difference between the current price and the option exercise price. The advantage of this solution is the much lower price of the option, which reduces the potential profits to a lesser extent.

An example is hedging a long position on Amazon stocks. At the end of the trading session on March 5, the value of one share is $ 3. The investor wants to hedge the position by purchasing a put option that expires on June 000, 18. The option exercise price is $ 2021. The option premium was $ 2. With this transaction, the investor hedges against a loss of less than $ 700 by paying $ 99,0 per share for that insurance. Therefore, the effective maximum loss level is $ 2 (maximum loss -700%). In the event of an increase in the rate, the profit on the transaction will appear only if it rises above $ 99,0.

Source: own study

Long position + ITM put option

The ITM (in-the-money) put option has an exercise price above the current market price. Due to the fact that the sale price is set above the current market price, the probability of exercising the option is higher than in the case of OTM and ATM options. As a result, the premium paid is much greater than for the ATM option. It is a strategy with much less potential loss. However, this strategy comes at the expense of very expensive "insurance", which greatly reduces your potential gains.

An example is hedging a long position on Amazon stocks. At the end of the trading session on March 5, the value of one share is $ 3. The investor wants to hedge the position by purchasing a put option that expires on June 000, 18. The option exercise price is $ 2021. The option premium was $ 3. Unlike the previous two, the premium paid for the option has two components: the intrinsic value of the option ($ 200) and a time bonus ($ 328,0). With this transaction, the trader hedges against a loss of less than $ 200. The effective level of maximum loss is $ 128 (maximum loss -3%). In the event of an increase in the rate, the profit on the transaction will appear only if it rises above $ 200.

Source: own study

Summary of married put

The married put strategy is the simplest hedging strategy against the decline in the value of an underlying instrument. Depending on the type of put option chosen, the cost of this insurance varies. 

Buying a put option, which is OTM, is the cheapest possible hedge against a market discount. However, the OTM option is only "insurance against disaster". It does not cost expensive, but it only protects against a very strong drop in the price of the underlying instrument. In the example above, the maximum loss is -13,3%. 

Buying a put option, which is ATM, is the most intuitive protection against a market discount. However, the ATM option is much more expensive than the OTM option. In the example above, the maximum loss on Amazon stock is 7,1%. The "higher premium" means that the profit on the transaction requires a significant increase in the company's share price. However, it should be remembered that buying an ATM put option is a hedge against a potential sell-off.

Purchasing a put option, which is ITM, is the most expensive way to hedge a long position on an underlying. This can be compared to buying a very extensive insurance. A broad package provides greater security, but has to cost more. In the Amazon stock example, the maximum loss is only 4,3%. However, it greatly reduces your potential gains.

Buying a call option as an alternative to married put

Creating a married put strategy is quite an expensive way to hedge your position. It requires the purchase of a portfolio of shares (long position) and the purchase of a put option (hedge). A cheaper alternative is to purchase a call option, which gives you exposure to increases and has protection against decreases, because the maximum loss is the size of the premium paid. As in the case of the put option, you can buy:

ITM call options

The ITM call option means that the strike price is lower than the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 2. The price for this option was $ 720 per share on March 5, 2021. This means the maximum loss is $ 385,95 on each share. It is the equivalent of having a long position and acquiring the OTM put option.

Source: own study

ATM call options

An ATM call option means that the strike price is close to the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 3. The price for this option was $ 000 per share on March 5, 2021. This means the maximum loss is $ 216,7 on each share. This is the equivalent of having a long position and acquiring an ATM put option.

Source: own study

OTM call options

The OTM call option means that the strike price is above the current market price. One such example is the Amazon stock option expiring on June 18, 2021. The option exercise price is $ 3. The price for this option was $ 200 per share on March 5, 2021. This means the maximum loss is $ 131,5 per share. This is the equivalent of having a long position and acquiring the ITM put option.

Source: own study

Summation

Married put is a strategy to protect against a decline in the value of an investment portfolio (eg shares). The strategy consists of a long position in an underlying asset (e.g. a stock) and a put option. As a result, the put option "earns" the decline in the price of the underlying instrument, and thus covers some of the losses generated by the decline in the value of the stock. The cost of this security is the premium paid by the investor. 

Do you know that…?

Saxo Bank is one of the few Forex brokers that offers vanilla options. The investor has a total of over 1200 options at his disposal (currencies, stocks, indices, interest rates, raw materials). CHECK

The result of the creation of a married put is a synthetic call option. Thanks to the use of the married put strategy, the investor limits the maximum loss while leaving himself the opportunity to earn in the event of a large appreciation of the underlying instrument. Depending on the type of put option (OTM, ATM, ITM), the strategy has a different risk-reward profile.