Protective put option

[scaft]

Hi,

I have a basic question of how an option works. I will assume an example to make the question more clear.

FACT:
It is said that 1 option contract controls 100 shares of stock

I will do this:

First step: BUY 100 shares of MSFT for 30 dollars.
Second step: BUY 1 PUT Option that controls my 100 shares of MSFT with a strike price of 30 dollars.

Question:

I buy 1 put option contract to protect my position. If we assume that the price will drop to 29 dollar in 1 minute not counting in any decaying timevalue in this example.

I now have the right to sell my 100 MSFT stocks for the price 30 dollar because I have an option contract.

But how will I do this practically? In my portfolio, I now have 100 shares of MSFT and 1 PUT Option contract. Because I can´t send a sell order for MSFT on 30 dollar since the market price is 29 dollars. This is the confusing part for me.

Simply, how will I exit this position on 30 dollars with what now exists in the portfolio?

Thank you

 

[Martinghoul]

Firstly, it matters whether the option in question is European or American. Leaving aside the question of whether it's economic to do so, in theory you could do the following (assuming the option contract you have bought is American): you could instruct your broker to exercise your put early, which would translate to you selling 100 shares of MSFT at 30.

Obviously, doing the above would be a relatively bad idea, but, as the owner of an American put, you have the option to do so.

 

[scaft]

Yes it is american which means I have the right to exercise the option before expiration.

>> you could instruct your broker to exercise your put early, which would translate to you selling 100 shares of MSFT at 30.

This is what I need to understand completely. When I do exercise the put, will this AUTOMATICALLY look in my portfolio and close the existing 100 shares of MSFT at 30 dollars(strikeprice), which means that I will never physically do any exit order for the 100 shares of MSFT?

If that is true, then it must be any kind of automatic link where an exercised option search for 100 shares of MSFT and also sell them?
If that also is true, what would happen if I don´t have 100 shares of MSFT in the portfolio and would it be possible to buy 1 PUT contract without having any MSFT shares in the portfolio from the very beginning?

Thank you!

 

[Martinghoul]

Yes it is american which means I have the right to exercise the option before expiration.

>> you could instruct your broker to exercise your put early, which would translate to you selling 100 shares of MSFT at 30.

This is what I need to understand completely. When I do exercise the put, will this AUTOMATICALLY look in my portfolio and close the existing 100 shares of MSFT at 30 dollars(strikeprice), which means that I will never physically do any exit order for the 100 shares of MSFT?

If that is true, then it must be any kind of automatic link where an exercised option search for 100 shares of MSFT and also sell them?
If that also is true, what would happen if I don´t have 100 shares of MSFT in the portfolio and would it be possible to buy 1 PUT contract without having any MSFT shares in the portfolio from the very beginning?

Thank you!

Anything is possible... There is no need to "look" in your portfolio to find the exact 100 shares of MSFT that you've originally bought. If you exercise the put, you will sell 100 shares of MSFT at 30. If you happened to be long 100 shares prior to exercise, the sell will net off against your long (MSFT shares are fungible) and you'll end up flat. If you weren't long, you'll end up short 100 shares of MSFT, which is perfectly feasible. So the answer is no, you don't have to own MSFT shares to buy the put.

 

[scaft]

Thank you

That was an excellent answer. That really cleared it out perfectly how the option works in that scenario which makes it easier to continue development.

Thank you again!

Anything is possible... There is no need to "look" in your portfolio to find the exact 100 shares of MSFT that you've originally bought. If you exercise the put, you will sell 100 shares of MSFT at 30. If you happened to be long 100 shares prior to exercise, the sell will net off against your long (MSFT shares are fungible) and you'll end up flat. If you weren't long, you'll end up short 100 shares of MSFT, which is perfectly feasible. So the answer is no, you don't have to own MSFT shares to buy the put.