Exercise PUT option question

[scaft]

Hi,

I have a question about what exercising a put option means in reality when placing such order.

I will try with this example:

Symbol: MSFT
Strikeprice: 30 dollar
PUT Option Bid: 2.00
PUT Option Ask: 2.30

Step1.
Buy 1 PUT option in MSFT

Step2.
Let us assume that we will exercise this PUT option.

Question:
When we do exercise this PUT option, that will in reality mean that we will SELL 100 MSFT shares for 30 dollar which was our strikeprice.
What I wonder about this is if those 100 shares of MSFT was "reserved" when we did the buy for the PUT option, which GUARANTEES that we actually can sell those 100 shares of MSFT, no matter what.

Is this how it works or is the order placed at current market conditions which means, if shares are avaliable at the very exact time in the market?

 

[Purple Brain]

Why you buy a PUT you are either covering an existing holding against loss in its underlying value or betting on a loss in value in an asset without physically owning it(I believe its effectively a proxy short in this case). If the underlying loses value you have the right to exercise your put and sell those assets at the strike price of your PUT purchased.

If you do not hold the underlying and wish to exercise your purchased PUT you will need to purchase the underlying at market. Obviously you wouldn't do this unless they had lost value against your PUT strike price and you could transact both purchase of underlying and exercise of PUT at a net profit.

That's about the limit of my knowledge of basic options so if that doesn't answer your query somebody with some real knowledge will have to step in.

 

[scaft]

Thanks! I will clarify the question if someone will know how it works exactly in this case.

>> If the underlying loses value you have the right to exercise your put and sell those assets at the strike price of your PUT purchased.

Yes, I assume that I am long 100 MSFT shares and after this I buy 1 PUT option at strikeprice 30 dollar to cover this position.

The exact question will be in this scenario when I exercice the PUT, will those 100 shares of MSFT be SOLD no matter what at the strikeprice 30 dollar or is this still dependent on current market conditions if actual shares are avaliable at the market at the exact time?

-Or-

Is the big difference that I have already reserved with 100% safety when buying the PUT to be able to SELL those 100 shares of MSFT at strikeprice 30 dollar?

 

[Purple Brain]

What do you mean "...or is this still dependent on current market conditions if actual shares are avaliable at the market at the exact time?". In your scenario you state YOU have 100 MSFT shares, so of course they are available to sell. You tell your broker. He sells them at market. He exercises against your PUT. You are credited with the sale of 100 @ $30 regardless of the current market price.

 

[scaft]

Yes I am long 100 shares of MSFT in the portfolio in this scenario, so it is true they are avaliable to sell.

BUT

As with normal stock orders we are never guaranteed to actually SELL those 100 shares for a duration of example
1 minute. The market conditions at the time can mean that no shares are avaliable.
This always is the case for normal stock orders without any OPTIONS.

The question is that when the broker exercises against the PUT, I do acutally sell those 100 shares of MSFT but someone must actually BUY those 100 shares of MSFT for 30 dollar strike price.
That can´t occur at current market condition as the stock price could for example be on 25 dollar now.
The question arises for me that it sounds that I must have done a contract with "someone" that I bought the PUT from at the beginning which makes it 100% sure that I will SELL those 100 shares of MSFT as it can´t occur at the current market price which is 25 dollar?
But are not exactly sure how it works here?

 

[Purple Brain]

No. Nobody buys your shares for $30. They are sold at market. Your broker credits you after exercising your PUT at $30. The actual 'person' who sold you the $30 PUT isn't in the picture. They were credited with the premium you paid for the PUT when you purchased it from them. They then are likely to have subsequently unloaded through any number of mechanisms to square that position away.

You pay $230 premium to purchase the PUT. The seller receives that premium.

Some time later...

You exercise your PUT and your 100 MSFT are sold at market ($25 but you really don't care what the market price is because...) your broker credits you with 100 X $30 = $3000.

Whoever effectively ended up holding that short PUT gets debited $3000 less the the credit of ownership of 100 MSFT @ $25 = net loss $500.

 

[Martinghoul]

Actually, not entirely correct here, folks... A lot of confusion. I would be happy to clarify, if you like.

 

[Purple Brain]

Actually, not entirely correct here, folks... A lot of confusion. I would be happy to clarify, if you like.

For my part, yes please. Got in out of my depth and didn't know when to let go.

Apologies to scaft if I was way off base. Even the basics perplex me on derivatives, but I thought I had a handle on the confusion you had with the disposition of the underlying on exercise.

 

[trendie]

Actually, not entirely correct here, folks... A lot of confusion. I would be happy to clarify, if you like.

Would greatly appreciate your review of the scenario, MG.

 

[Martinghoul]

It's really very simple. If I have bought a put and I decide to exercise it early, it really doesn't matter whether I am long or short the shares. It also doesn't matter where the underlying is trading in the market at the time when I exercise. If I decide to exercise my $30 strike put, I will be selling the underlying at $30 and that's that.

In terms of the mechanics of this, what happens is the following. Since I am long the put, there's someone out there who is short the put against me (in reality, it's not like the put has our names on it, but for every long there has to be a short). When/if I decide to exercise my put early (as is my right, since I am long the option), there will be a victim (chosen randomly) among the shorts who will be assigned. This victim will be forced by their broker to buy MSFT at $30, regardless of where it's trading in the mkt at the time of exercise.

That's pretty much all there is to the process. Finally, let me just add that, generally, it's pretty much always suboptimal and uneconomic to exercise an American option early.

 

[scaft]

>> This victim will be forced by their broker to buy MSFT at $30, regardless of where it's trading in the mkt at the time of exercise.

This was exactly what I had in the back of my mind that it had to be any kind of "contract" against someone else.

Your description did clarify. First I needed to understand the mechanism of how it did work. The other is where I needed to know the difference against a normal order.
As I do programming this scenario in code, I need to understand that when exercising a PUT that means 100% guarantee of exercising at $30 dollar strike at any time before expiration(just the mechanism, not if it is suboptimal in the sense of mechanism), where it is not nessecary to "try" again if no shares were avaliable as I usually do with stock orders, because:

">> This victim will be forced by their broker to buy MSFT at $30"?

If I can have a yes confirmation on that one, I have cleared it out very much.

 

[Martinghoul]

Well, I don't really want to give you an unconditional "yes", but the put contract gives you the RIGHT to sell at $30. If you're denied that right, for whatever reason, the terms of the contract have been breached. While it's possible in theory (I guess), I have never heard of this happening and it would be a pretty crazy thing, if it were to occur.

One thing to note, of course, is that, ultimately, everything is up to your broker. For instance, if you want to be properly paranoid, you could imagine all sorts of scenarios.

 

[scaft]

That gives a clue anyway of in what direction to think and how it works.
I try to find a guidingline for the scenario in order to start out correctly.

You clarified alot of things which makes much easier to understand the mechanisms.

Thanks!

Well, I don't really want to give you an unconditional "yes", but the put contract gives you the RIGHT to sell at $30. If you're denied that right, for whatever reason, the terms of the contract have been breached. While it's possible in theory (I guess), I have never heard of this happening and it would be a pretty crazy thing, if it were to occur.

One thing to note, of course, is that, ultimately, everything is up to your broker. For instance, if you want to be properly paranoid, you could imagine all sorts of scenarios.