What Is a Put on a Put?
Essentially, a put on a put option is an option to sell an option. The underlying asset of the put on a put option is the original option. Put on a put options are more common on European exchanges than in the United States.
- A put on a put is an options contract that gives its buyer the right to sell an underlying options contract.
- The underlying asset of the put on a put option is a vanilla put option.
- A put on a put is essentially an option to sell an option.
Put on a Put Explained
The buyer of a put option is a trader who expects the asset upon which the option is based to fall in price. The trader purchases a put option, usually for 100 shares, that allows the shares to be sold at a certain price (the strike price) by a specified expiration date. If the trader is correct and the asset falls, the option is in the money and can be exercised, with the trader profiting from the difference between the option price and the market price.
A put on a put option involves two put options, one over the other. A put on a put has two strike prices and two expiration dates. One is for the compound put option and the other is for the underlying vanilla option.
Note that compound options are more common in Europe, and European options can be exercised only on the expiration date. An American option can be exercised on or anytime before the date of expiration.
Since one of the variables that determine the cost of an option is the price of the underlying asset, the cost of a put on a put option will generally be lower than the cost of a vanilla put on the corresponding asset. Thus, it can provide some leverage to the options trader.
When to Use a Put on a Put
A put on a put option is used when a trader wants to employ leverage. The trader will also be moderately bullish on the underlying asset. The value of a put on a put changes in direct proportion to the price of the underlying asset. This means the value increases as the asset price increases, and decreases as the asset price decreases.
Other Compound Options
The other three types of compound options are:
- Call on a put: This is a call option on an underlying put option. The owner who exercises the call option receives a put option.
- Call on a call: In this option, the investor buys another call option with customized provisions. These provisions include the right to buy a plain vanilla call option on an underlying security.
- Put on a call: The investor must deliver the underlying call option to the seller and collect a premium based on the strike price of the overlying put option.
These options are also known as split-fee options.