A Beginner's Guide to Buying Puts

How to utilize leverage to short a stock without risking excessive capital

Jan 21, 2015 at 10:53 AM
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Hello again, aspiring options traders! In case you missed it, last week I discussed the basics of buying call options. This week, we will be discussing the other type of options contract -- the put.

While buying a call is essentially betting that a stock's price will increase in a set duration of time, buying a put option is betting that a stock's price will decrease over a pre-determined time span. While a call contract allows the holder to buy 100 shares of a stock at a pre-determined price, a put contract affords the holder the right to sell 100 shares of a stock at a pre-determined price.

Put buying is quite similar to short selling, in terms of the outlook for the underlying stock, but differs in that the purchaser of a put doesn't have to borrow actual shares of a stock. In addition, the risks are much slimmer with put buying, as compared to selling a stock short, while the potential rewards are roughly equivalent. Let's break down how put options work, step by step.

Advantages of Put Buying

Let's say that our hypothetical investor from last week's column -- "Jim" -- believes that shares of XYZ are going to plummet over the next few months. However, Jim doesn't want to invest a large portion of his available capital via shorting the stock, which risks a relatively significant amount of cash and could lead to theoretically infinite losses. So, he decides to purchase a put option at the price that he thinks XYZ is going to breach, known as the "strike price."

Say that shares of XYZ are currently trading at an even $100, and rumors that the company may come up short on its upcoming earnings report have Jim convinced that the equity is going to plummet over the next couple of months. Jim could purchase the March 95 put, which expires at the market close on Friday, March 20. The ask price for that option is $2, and since every option contract represents 100 underlying shares, the price for one contract would be $200 ($2 ask price x 100 underlying shares).

If shares of XYZ are trading at $95 -- around the strike price -- the put is considered "at the money." The contract will be "in the money" if XYZ plummets south of $95 within the option's lifetime, and will be "out of the money" if XYZ is north of $95.

If Jim's bearish prediction is correct, and XYZ drops below the strike price of $95 prior to expiration, he has two separate paths he can take. First, he could exercise the option, which means he can sell 100 shares of XYZ at $95 apiece, the pre-determined strike price -- a premium to the current market value. Second, he could also sell to close the put, where he would simply sell the in-the-money contract for a profit.

Whatever course of action Jim decides to take, he must pay close attention to the expiration date. Starting in February, monthly options expire at market close on the third Friday of every month, though many popular stocks also have weekly options that expire every Friday of the month. Let's explore Jim's potential outcomes a bit more in-depth.

Outcome #1: Jim is correct, and an underwhelming earnings report sends shares of XYZ falling to $85. He could then sell to close his option (now worth $10 in intrinsic value -- stock price minus strike price) before expiration, for $1,000 ($10 x 100 underlying shares). Since Jim only paid $200 for his initial put contract, his total profit would be $800, for an incredible 400% profit on his small investment.

Possible outcomes for XYZ 95-strike put

Outcome #2: As discussed earlier, had Jim decided to short-sell shares of XYZ by borrowing 100 shares at $100 each, it would have cost him no money upfront -- though a typical short trade involves setting aside a margin requirement of 150% of the proceeds, thereby tying up a significant amount of capital for the duration of the trade. After the stock's tumble to $85, his position would be worth $1,500 -- a nice chunk of change. While this is $700 more than the profit he would have made off the 95-strike put, it represents a gain of just 15% on the trade, compared to the 400% the comparable options play would have returned. Again, this is called leverage -- or the principle of wagering relatively modest amounts of capital in order to gain profits much larger than the original bet.

Outcome #3: Had shares of XYZ risen to $110 instead of falling to $85, Jim would only be out his initial premium of $200 on the 95-strike put, no matter how high the shares should rise above the strike price. On the other hand, if Jim had sold the stock short at $100, he would be out $1,000 on a move up to $110. If the shares had risen to $120, Jim would be out $2,000, and on and on.

In other words, short selling carries substantially more risk than buying puts. If Jim were to have a traditional short stock position on XYZ, his potential losses could be theoretically unlimited, considering there's no limit to how high the stock can rise. With a put, his losses are maxed out at the premium he paid for his contract.

Next week, we will delve into a side-by-side comparison of options trading versus investing in traditional stocks, and why options trading makes sense for certain types of investors.

Disclaimer: None of the hypothetical scenarios above take into account brokerage or commission fees, which are an inescapable part of options trading.

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