Beginning Option Strategies/Bearish Strategies

Options 101: The Principles of Put Buying

This article examines one of the most elementary forms of options trading: buying puts.

What is a put? While a call buyer has the right to purchase a stock at a predetermined price, a put gives the buyer the right (not the obligation) to sell an underlying security at a predetermined price (strike) before a certain time (options expiration). Each contract generally represents 100 shares of the stock, with options available in a variety of strike prices and expiration dates.

Who should tune in? Investors typically purchase puts for a couple of different reasons. First, these options allow the trader to profit from a stock’s decline. Second, a nervous investor can buy puts as a hedge – or a form of “portfolio insurance” – to protect against a market downturn. However, for the sake of simplicity, we’re going to focus on Reason No. 1.

How does it work? After the trader singles out a stock ripe for a pullback, she would then determine her specific expectations for the security. The distance and length of the anticipated downturn should correlate with the bought put’s strike and expiration. (For example, if the investor thinks the shares of XYZ will fall beneath the $50 level by October options expiration, she might buy the XYZ October 50 put.)

What’s in it for me? The goal of this simple strategy is for the underlying security to backpedal beneath the put strike by options expiration. The put’s value will increase with each step below the strike price (intrinsic value), meaning maximum potential profit is limited to the strike price minus the premium paid for the put, since the lowest the underlying stock can fall is zero.

If a put is in the money (stock price < strike price) close to expiration, the put buyer has a couple of options. First, she can sell the option for a profit, considering it would be worth more than what she originally paid. On the other hand, she could exercise the put – meaning she could invoke her right to sell the underlying shares at the strike price. Considering the stock would be trading at a discount to the strike price, unloading the shares to the person across the options aisle would net a higher profit than what she’d receive for selling those same shares on the Street.

(According to Options Clearing Corporation, about half of all options are eventually bought or sold to close, while only about 17% are exercised; the other third or so typically expire worthless.)

What do I have to lose? Purchasing puts is often considered a more appealing alternative to selling a stock short. For starters, put buyers don’t have to meet margin requirements or borrow the underlying shares, unlike short sellers. Most notably, though, the put player’s maximum potential risk is limited to the initial premium paid for the option, while a short seller’s risk is theoretically unlimited.

In order to avoid a loss on the play, the investor needs the underlying stock to remain beneath the breakeven level, which is tallied by subtracting the initial premium paid from the put strike.

(Don’t forget to include any brokerage fees or commission costs.)

Let’s look at an example

Meet Jack, a novice option trader with his eyes on stock XYZ. The shares recently rallied into resistance at their 20-week moving average, which hasn’t been breached on a weekly closing basis in years. As Jack expects the trendline to smack XYZ lower in the short-to-intermediate term, he decides to capitalize on a potential pullback by purchasing a put.

Technically speaking, the security’s 20-week moving average is lingering in the $30 region. Considering Jack expects XYZ to backpedal beneath this level in the near term, he opts to buy the October 30 put, which was last asked at $2, or $200 (x 100 shares).

Theoretical put purchase on stock XYZ

In order to break even on the position, Jack needs the shares of XYZ to dip beneath the $28 level (strike – premium paid) before October-dated options expire. However, should the security muscle past long-term resistance in the $30 region, the most Jack can possibly lose on the play is the initial $2 paid to buy the put.

On the other hand, let’s assume the shares of XYZ do get smacked lower by resistance, falling to the $20 level as a result. The October 30 call would be 10 points in the money, making the option’s intrinsic value $10. By closing the position, Jack would sell his put for $10, or $100; subtracting the $2, or $200, originally paid for the option, his position would net a profit of $8, or $800 (x 100 shares).

In conclusion

Put buying is one of the most basic option plays, utilized to profit from a stock’s downward momentum. The appeal of this strategy is multi-layered, and includes limited risk and the absence of margin requirements. However, to find success with put buying (or option trading in general, for that matter), it’s important to determine your specific expectations for the underlying equity before making the purchase, in order to maximize your profit potential.

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