Buying Put Options
Outlook: Bearish
If you're bearish on a particular stock, you could buy put options in order to profit from the predicted decline. Buying one put is comparable to shorting 100 shares of the underlying security, but the option trade offers an inherently more conservative risk profile than shorting the stock outright. Let's take a closer look at long put options by examining a hypothetical trade.
Entering the Trade
You're downbeat on the prospects for XYZ, which is currently trading at $35 per share. Over the next two months, you predict the stock will decline significantly.
To capitalize on this expected move lower, you buy (to open) one 37.50-strike put option with two months until expiration, which is asked at 3.85 (2.5 points intrinsic value + 1.35 points time value).
As such, you'll pay $385 to purchase one put option controlling 100 shares of XYZ (3.85 premium x 100 shares). Conversely, selling the same amount of stock short theoretically has you on the hook for $3,500.
Potential Gains
In the best-case scenario, XYZ would fall clear down to zero by the time your option expired. This would reap the maximum potential profit on your option -- which would be $33.65 (strike price of 37.50 minus net debit of 3.85).
In fact, $33.65 (strike price less net debit) also happens to be the breakeven point on your purchased put option. This means you'll collect a profit as long as XYZ finishes anywhere below $33.65 upon expiration.
If so, you'll have one of two choices:
You can sell to close your option, and pocket any gain in the contract's value as your profit on the play. For example, let's say XYZ is trading at $30 per share on expiration Friday. Your 37.50-strike put would be worth 7.50 (7.5 points intrinsic value; no time value remaining). By selling to close the option for $750, your profit would be $365 -- representing a 95% return on your original investment of $385.
(Meanwhile, a short seller could buy back his borrowed shares for $3,000, netting a gain of $500 -- or just 14.3% of the amount he initially risked.)
Alternately, rather than selling to close, you can exercise your option to sell 100 shares of XYZ at the strike price of $37.50.
Potential Losses
The most you can possibly lose when trading long put options is limited to your initial cash outlay -- in this case, $385, plus any brokerage fees. This maximum loss will be realized if XYZ finishes at or above $37.50 upon expiration.
By comparison, should XYZ unexpectedly rally, a short seller's risk is theoretically unlimited.
Volatility Impact
As with all premium-buying strategies, holders of long put options will pay a richer premium when implied volatility is high relative to historical levels. Put buyers should compare the option's implied volatility against historical volatility readings for a comparable time frame, and capitalize on scenarios where options appear to be underpricing volatility.
Other Considerations
As with calls, put options on a dividend-paying stock will price in the impact of any dividend set to be paid during the lifespan of the contracts. Whereas scheduled dividend payments lower the cost of call options, these occurrences raise the cost of put options, since the stock will move south on the ex-div date.
