There's more than one way to play puts -- even if you're bullish on the underlying stock
Last week, we took a look at three different ways to play calls. This week, we are going to continue our educational series by taking a look at three different ways to play puts.
Long Puts
The long put is a basic option strategy. The buyer purchases put options with the belief that the price in the underlying security is going to drop significantly below the strike price before the expiration date. The maximum profit on a long put is theoretically unlimited (down to zero), and the maximum loss is the premium paid plus any commissions paid. This unlimited profit and limited loss is what makes the long put a very attractive investment vehicle.
Example: Stock ABC is trading at $40 and a 40-strike put option contract with three months until expiration is priced at $2. If you believe that ABC is going to fall beyond the $40 strike, you could purchase the option for $2, or $200 (since one contract controls 100 shares).
Let's say the stock plummets to $30 -- your 40-strike put is now 10 points in the money. You could then sell to close the put for $10 (or $1,000, after multiplying for 100 shares), making $800 on the trade ($1,000 less the original $200 to purchase the put). Or you could exercise the put and sell ABC shares for $40 apiece -- a significant premium to their Street value.
If you are wrong (which could happen) and the stock rallies past $40, you could simply let the options expire worthless. You'd be out $200 (plus commissions), but that's significantly less than what you'd risk selling the stock short.
Put Spread
The bear put spread is an option trading strategy to use if you think a stock's price is going to drop moderately in a short amount of time, and you're willing to sacrifice some potential profits by limiting losses even more than a "vanilla" long put.
A bear put spread is executed by purchasing a put and selling an out-of-the-money (OTM) put with a lower strike. Both puts will have the same expiration date. By selling the lower-strike put, you have lowered the cost of the bearish position, but you are sacrificing the chance to make a large profit if the stock goes into a free fall. Maximum profit is achieved when the stock closes at or below the lower strike on the expiration date. Both options will be in the money (ITM), but the higher-strike put will have a higher intrinsic value than the lower strike price. This means that the max profit potential for the spread is the difference in strike prices, less the initial debit.
Example: Stock ABC is trading at $38 in July. You could buy to open a July 40 put for $3 and simultaneously sell to open a July 35 put for $1. The net debit for the spread is $2. If ABC falls to $34 at expiration, both puts will be ITM, and you could pocket $3 ([40 strike - 35 strike] - $2 debit).
If the stock had rallied past $40, both options would expire worthless. You would lose the initial debit of $200 to enter the trade. However, that's less than the $300 you would've forfeited had you simply bought to open the July 40 put.
Protective Put
The protective put is a strategy used to protect an investment. If you own a stock -- and are therefore bullish -- but are concerned about a correction or drop in price, you could protect your investment by using a protective put.
Example: You bought shares of ABC at $35, and they're now trading at $50. However, you're concerned about a pullback, so you purchase an intermediate-term 48-strike put for $1, to hedge your shares.
Should ABC continue to rally, bully for you! You can hang on to your shares and chalk up the protective put as simply the cost of peace of mind. Should ABC dip to $45, you could exercise your put and sell your shares at $48 apiece -- locking in most of you gains.
Next week we will take a deeper look at ways to play puts, so make sure to check back and learn more about option basics. Remember, you can always take advantage of our Getting Started with Options home-study program -- click here for more information.