Series 3: 4.3.2.1. Short Puts

4.3.2.1. Short Puts

A short put will hedge a short inventory position in the same way as a covered call hedges a long position. An at-the-money put reduces losses no more than the amount of the option premium, and it caps gains by an amount equal to the premium.

Suppose a U.S. importer contracts for a shipment of pharmaceuticals valued at €400,000 to be delivered in December. The cash price for euros is currently $1.12, and the at-the-money put option is selling at two cents. Expecting the euro to remain relatively constant, the importer elects to earn some additional income by shorting puts. This is a partial hedge because he can reduce his potential losses by the income he earns from the puts. It also limits the amount he can make if the U.S. dollar strengthens against the euro.

At €10,000 per contract, the importer shorts 40 at-the-money put options (€400,000 / €10,000 per contract = 40). The hedge will decrease his costs by up to $8,000 if the euro strengthens against the dollar ($0.02 per euro x 400,000 euros). If the euro weakens by up to 2.0 cents per euro, it will eliminate his losses. Any further weakening will cost him more, but he still will have reduced his lost revenue by $8,000.