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Maximum Loss on a Short/Long Put

Course: Investment Planning
Lesson 15: Fundamentals of Derivatives – Futures and Options

Student Question:

So, if the max loss on a short put is the strike price less the premium, and the breakeven point is also the strike price minus the premium, does that mean the max loss is breaking even? And does the same go for max profit on long puts? Thank you!
Lafe


Instructor Response:

Hi Lafe, Great question. Let’s translate the conceptual into an example: Short Put

When Acme was trading at $52, I sold (wrote) a $60 put on Acme, Inc. for $4

  • Maximum Profit
    • Stock subsequently trades at $60 or more
    • The holder of the put allows the option to expire
    • My max profit is the premium income of $4
  • Breakeven
    • Stock subsequently trades at $56
    • The holder exercises – I must pay $60 for a share that is worth $56
    • I lose $4 at the exercise date but I received a $4 premium when I sold the put
    • I’ve broken even on the profit
  • Maximum Loss
    • Stock subsequently trades at $0
    • The holder exercises – I must pay $60 for a share that is worthless
    • I received $4 premium
    • My loss is $56 [strike price less premium]

Long Put
When Acme was trading at $52, I bought (hold) a $60 put on Acme, Inc. for $4.

  • Maximum Profit
    • Stock subsequently trades at $0
    • I exercise the option and receive $60 from the writer for a worthless share
    • I paid a $4 premium
    • My max gain is $56 [strike price less premium]
    • This is the mirror image of the max loss from the writer of the put
  • Breakeven
    • Stock subsequently trades at $56
    • I exercise the option and receive $60 for a share worth $56
    • I made $4 on the sale of the share but the option premium was $4
    • I’ve broken even on the profit
  • Maximum Loss
    • Stock subsequently trades at $60 or more
    • I do not exercise my put option
    • My max loss is the premium of $4

Bruce