An investor purchasing a put while at the same time purchasing an equivalent number of shares of the underlying stock is establishing a “married put” position – a hedging strategy with a name from an old IRS ruling.
Bullish to Very Bullish
When to Use?
The investor employing the married put strategy wants the benefits of stock ownership (dividends, voting rights, etc.), but has concerns about unknown, near-term, downside market risks. Purchasing puts with the purchase of shares of the underlying stock is a directional and bullish strategy. The primary motivation of this investor is to protect his shares of the underlying security from a decrease in market price. He will generally purchase a number of put contracts equivalent to the number of shares held.
While the married put investor retains all benefits of stock ownership, he has “insured” his shares against an unacceptable decrease in value during the lifetime of the put, and has a limited, predefined, downside market risk. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the underlying stock decreases in value during the option’s lifetime, the investor has a guaranteed selling price for the shares at the put’s strike price. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at a time and at a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price, and control over when he chooses to sell his stock.
Risk vs. Reward
Maximum Profit: Unlimited
Maximum Loss: Limited
Stock Purchase Price – Strike Price + Premium Paid
Upside Profit at Expiration: Gains in underlying share value – Premium Paid
Your maximum profit depends only on the potential price increase of the underlying security; in theory it is unlimited. When the put expires, if the underlying stock closes at the price originally paid for the shares, the investor’s loss would be the entire premium paid for the put.
BEP: Stock Purchase Price + Premium Paid
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option’s total premium is on the time value portion.
Passage of Time: Negative Effect
The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.
Alternatives before expiration?
An investor employing the married put can sell his stock at any time, and/or sell his long put at any time before it expires. If the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining.
Alternatives at expiration?
If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option expires in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put’s strike price. Alternatively the investor may sell the put option, if it has market value, before the market closes on the option’s last trading day. The premium received from the long option’s sale will offset any financial loss from a decline in underlying share value.