Put option payoff example

Put Option: creating leverage

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Put option payoff example

From the Real Estate Put Options example provided here, let us assume that a homeowner lives in La Jolla, CA and the derived value of the property on January 1st, 2008 at $1m. Considering a historical rate for San Diego real estate returns, assume that the property value will decline to, say $0.8m in 5 years.

We use binominal pricing and historical price volatility. Below are four Real Estate Put Options scenarios, which differ by strike price.

	Option 1	Option 2	Option 3	Option 4
Property Value on Jan 1. 2008	$ 1,000,000	$ 1,000,000	$ 1,000,000	$ 1,000,000
Term years	5	5	5	5
Strike Price	$ 700,000	$ 800,000	$ 900,000	$ 1,000,000

Option Price (1,000 shares per contract)	$ 311 or $0.33 per share	$ 3,062 or $3 per share	$ 12,111 or $12 per share	$ 40,042 or $40 per share
Derived Value in Year 5	$ 800,000	$ 800,000	$ 800,000	$ 800,000

Put Payoff	-	-	$ 100,000	$ 200,000

Let’s review Option 1

The property is valued on Jan 1st, 2008 at $1m. The term of the put option is 5 years with a strike price of $0.7m. The investor receives $0.31 per share today. The property value derived on Jan 1st, 2013 is $0.8m. The derived value is above the strike price of $0.7m and, therefore, investor payment is $0. This option is “out the money.” Options 1 and 2 are “out of the money.”

In contrast, let’s review Option 3

The property is valued on Jan 1st, 2008 at $1m. The term of the put option is 5 years with a strike price of $0.9m. The investor receives $12 per share today. The property value derived on Jan 1st, 2013 is $0.8m. Option payoff is the difference between the strike price $0.9m and the price in year 5 of $0.8m which is $100,000 or $100 per share, therefore, investor payment is $100 per share owned. Options 3 and 4 are “in the money.”

Put Option: creating leverage