When a trader buys a put option, they are hoping that the underlying price falls, and specifically that it falls below their strike price. The strike price though, is not the price at which the trader will breakeven at expiration. This is because the option was not free, a premium was paid. This premium must be taken into account to calculate where the option will break even if held to expiry.
In example 3 in the previous lecture, you may remember we bought an SLV put option with a strike price of $21, and then it expired with the price of SLV at $20, which is below our strike price. This means the option had an intrinsic value of $1. However, because we paid a $1.54 premium for the option, we lost $0.54 per share on the trade overall.
It is useful when buying put options, particularly if you’re planning to hold them to expiry, to know what price the underlying needs to reach for your trade to break even. Thankfully this is a very simple calculation.
In that example where the strike price of the put option was $21, and the premium paid was $1.54, the breakeven point is simply
$21 – $1.54 = $19.46
This means that if the price of SLV is exactly $19.46 when the put option expires, the trade will have made precisely $0. No profit, but no loss either.
General formula
More generally, the breakeven point of a put option can be calculated as:
Breakeven Point = Strike Price – Premium Paid
It’s important to remember that it’s the premium paid per share that you need to use when making this calculation. You’ll remember that the contract multiplier for SLV was 100, so when we purchased the put option, the total premium paid was actually $154. It is the per share price of $1.54 though, that we use when making the breakeven calculations.
More examples
As the calculation is simple when only considering one put option at a time, it’s possible to do this calculation on the fly while looking over the option chain.
For example, a $20 put option with an ask price of $1.12. If we were to purchase this put for $1.12 and hold it until expiration, our breakeven point would be the strike price of $20 minus the premium paid of $1.12, which equals $18.88.
For a $17 put option with a current ask price of $0.35. If we were to purchase this put for $0.35 now and hold it until expiration, our breakeven point would be $17 minus $0.35, which equals $16.65.
We will be moving on to the differences between buying and selling a put option later in the section. It’s worth mentioning briefly now though, that the breakeven point for the seller of the put option is exactly the same as the breakeven point for the buyer of the put option.
In summary
The breakeven point of a put option can be calculated as the strike price minus the premium paid for the option.
Remember to use the per share value for the premium paid, not the total premium.