Personal Finance & Money Asked by borejwaz on July 15, 2021
My apologies if this is too simple a question, but there’s a (possible) misconception that I wanted to clear. I did search for resources on the web and I think I have understood about 90% of the mechanics involved but there are some aspects that I don’t think I have properly understood.
For the rest of this post, I am focusing on the worst-case scenario.
Given my personal circumstances and risk appetite, I don’t think I will ever buy shorts since they have an unlimited associated risk. However, for lesser returns (esp. factoring in theta decay), buying puts can serve a functionally similar purpose.
Either owing to faulty advice or my inability to comprehend what was being said during a lunch with my ex-colleagues, I have formed a conception that at expiration puts are converted to shorts. On the contrary, the recent YouTube videos that I have seen and some blog articles that I have read, seem to suggest that puts have limited risk involved. Which of these two things is true (since if puts become shorts the latter represents unlimited risk)?
Consider a worst-case scenario where I am hospitalized for a month (say for COVID-19) and the date of expiration coincides with the mid-point of my stay in the hospital. Is there an action that I have to take to prevent puts from turning into a contract that represents unlimited risk? I don’t mind a scenario where a $1000 worth of puts turn worthless at expiration. It’s a costly lesson for sure, but it’s something that can be lived with. However, I don’t want a scenario where after coming out of the hospital I have in my hand a contract that makes me responsible for hundreds of thousands of dollars (the whole point in avoiding shorts in the first place).
For any and all scenarios: Is it true that the risk in buying puts is limited? Is it true that the maximum amount I can lose in puts equal to the amount I spent while buying them?
For any and all scenarios, it is not true that the risk in buying puts is limited.
When you buy an option to open, you are long that option. When you sell an option to open, you are short that option (opening transactions). You can sell to close a long option or buy to close a short option any time before expiration.
Exercised American style options turn into equity positions (index options can only be exercised at expiration and they are settled in cash). For this discussion, let's assume that no stock is owned and there are no short stock positions.
The owner of a long put has the right to exercise his option and sell the underlying at the strike price. If he does so, he becomes short the stock. The counterparty who is assigned becomes the owner of the stock.
The owner of a long call has the right to exercise his option and buy the stock at the strike price. If he does so, he becomes long the stock. The counterparty who is assigned sells the stock, becoming short the stock.
Only short stock has unlimited risk. With assignment, long stock can lose no more than the strike price less the premium received by the seller.
Traditionally, one could lose no more than the premium paid for a long option. However, about 15 years ago the SEC approved a rule called Exercise by Exception which means that if an option is one cent or more in-the-money (ITM) at expiration, the Option Clearing Corp (OCC) will automatically exercise it whether it is long or short. That means that an exercised long ITM put will become short stock with the aforementioned unlimited risk.
If you are long the option, you can designate to the OCC via your broker that it is not to be auto exercised at expiration. This would make sense if it is ITM by pennies and your commission and/or fees to close the position exceeds the ITM amount. It would also manage the scenario of your hospitalization risk.
I would assume that you could make this designation at any time but you should check with your broker rather than accept my assumption.
Is it true that the maximum amount you can lose in puts equal to the amount you spend while buying them if you request that they not be exercised by exception.
Correct answer by Bob Baerker on July 15, 2021
For a cash-settled index put, you are completely safe.
For an equity put, the risk is that it expires in-the-money and is exercised, leaving you with a short position that can then move against you. To avoid this, before expiration, you must either sell the put or buy the stock. As long as you take action before expiration, your risk is limited.
Answered by nanoman on July 15, 2021
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