What are the risks of buying put options as a hedge?

edcyhn: What are the risks of buying put options as a hedge?
I currently own 288 shares of VTI (total market ETF) and am considering buying a couple of put options to partially hedge my position. I have never bought an option before. What are the risks?

If there were a catastrophic market collapse, with VTI going down to say 40 (from 71) this summer, and I were holding a put option to sell for say 65, would I have any trouble exercising it?

Should I buy 3 option contracts, to cover my entire position?

Answers and Views:

Answer by Common Sense
The good news is… the volatility on VTI is incredibly low. So…. the cost of your option is very low. If you don’t understand this…. you need to learn about “The Greeks” in regards to options.

The main risk of an option is you’ll lose your entire investment (cost of the option).
You should read a couple of books (at least) on Options to understand them better. It is… a somewhat complex subject…….

If there was “market collapse” as you describe….. you’d just sell the option…. it generally makes no sense to go to the expensive and trouble to exercise the option. Generally… but not with a low VOL like this option….. it makes sense to sell 30 days prior to expiration. With such a low VOL your time decay won’t be much.

Check the open interest before buying….. you’ll get a feel on how popular the option you’re picking is…….

2 or 3 contracts… it’s up to you.

Answer by John W
There won’t be any problem exercising the option. Although the options are initially written by individual investors, they are done through their broker and a clearing house so the options are underwritten by both the broker and the clearing house. The original writer of the option would be given a margin call long before he became unable to fufill his obligation and even if he couldn’t, his broker or failing that the option clearing house would honor the contract.

Of course the more probable that the stock price will drop, the higher the put option premium will be. The volatility is how the probability of the prices are estimated the low volatility of VTI is indicative that the put option has a lower probability of being needed by the buyer. The downside of selling the option early instead of exercising it is that doing so will not protect against further declines in price, of course it also has the advantage of leaving you with the ETF shares if you are still bullish on VTI. If it’s a catastrophic collapse that you are trying to protect against, you would just hold the option through expiration, exercise and decide then whether or not to resume the position in VTI. Each option contract gives you the right to sell 100 shares, although you have only 288 shares to sell, if the share price is less than the strike price of the option, you could easily buy 12 shares at the lower market price to sell to the put option so there is no downside to buying three puts other than the added premium cost, buying 2 put contracts means that you only have the right to sell 200 shares to the contracts at the strike price and you’re taking your chances with the remaining 88. It’ difficult to sell an option for a fair price in the last thirty days before expiration because the assumption is that the seller does not have the means to exercise so the buyers will low ball to reap the benefit of an in the money option for themselves.

If you’re close to expiration, it’s better to exercise at expiration. Remember that when you sell, the buyer must have an incentive to buy i.e.: they want to make money too, the Black Scholes equation only gives you an upper bound for the price and the buyer will want a cut of the intrinisic value of the option hence close to expiration, you will always be realizing less than you would by exercising regardless of how low the volatility.