Put options are a type of option that increases in value as a stock drops. The benefit of puts is that they can appreciate fast on a little movement in the stock market. This feature makes them popular for traders who are looking to make a big profit quickly. However, most investors scare away from put options trading because of the risks. These risks can be reduced by having prior knowledge of the put options strategy. This article will discuss extensively on buying and selling of put options. We’ll discover how buying a put option work by looking at an example.
The significant elements of an option would be the following:
- Strike price: The price at which you can buy an underlying stock.
- Premium: The price of this option, for both buyer or seller.
- Expiration: Once the option expires and can be settled.
One option is known as a contract, and every contract represents 100 shares of the underlying stock. Contracts are priced in terms of the worth per share, rather than the entire worth of their contract. For instance, if the trade prices an option at $1.50, then the expense to buy the contract would be $150, or (100 stocks * 1 contract * $1.50).
Read Also: PUT OPTIONS: How to trade put options in simple steps
Buying a Put Option
The put buyer has the right to sell a stock at the strike price for a set amount of time. For that right, the put buyer pays a premium. If the price of the underlying moves below the strike price, the option will be worth money. The buyer can sell the option for a profit (this is what many put buyers do) or exercise the option.
It’s only rewarding for the put buyer to exercise their option when the current price of the underlying is below the strike price. For example, if the stock is trading at $11 on the stock market, it is not worthwhile for the put option buyer to exercise their option to sell the stock at $10. This is because they can sell it at a higher price in the marketplace. So how does buying a put option work?
How Does Buying a Put Option Work
Buying a put option work as traders buy a put option to maximize the profit from a stock’s decline. For a small upfront price, a trader can profit from stock prices below the strike price before the option expires. By buying a put, you usually expect the stock price to collapse until the option expires.
Just like with call options, you can buy put options through brokerages like Fidelity or TD Ameritrade (AMTD). This is because options are financial instruments similar to stocks or bonds, so you can similarly trade them. However, the process of buying put options is a bit different as they are essentially a contract on underlying securities.
To trade options in general, you will need approval by a brokerage for a certain level of options trading. According to the various criteria, they typically classify the investor into one of four or five levels. Also, one can trade options over-the-counter (OTC), which eliminates brokerages and is party-to-party.
Options contracts typically consist of 100 shares and can be set at varying expiration dates (weekly, monthly, or quarterly). In buying an option, the investor focuses on two major places, the strike price and the premium for the option. For example, you can buy a put option for Facebook (FB) at a $7 premium having a strike price of $143.
Buying a Put Options Strategy
The general motivation behind a put options strategy is to capitalize on being bearish on a particular stock. However, there are plenty of different strategies that can reduce risk or maximize bearishness.
#1. Long Put
This is one of the most basic put option strategies.
When buying a long put option, the investor is bearish on the stock or underlying security and thinks the price of the shares will go down within a certain period of time. For example, if you are bearish on Apple (AAPL)stock, you could buy a put option on Apple stock with a strike price of $150 per share. You probably think its market value will decrease to around $145 in six months.
Since the current price of Apple stock is around $153 per share, your put option would be “out of the money” and will be worth lesser. The more bearish you are, the more “out of the money” you’ll want to purchase the stock. However, if the stock price declines before the expiry date, you would make a nice profit by exercising your put option. Also, you’ll profit by selling shares of Apple stock at $150 instead of the lower market price they are now worth.
#2. Short Put (Naked Put)
The short put is a strategy that expects the price of the underlying stock to actually rise or remain at the strike price. Hence, it is more bullish than a long put.
The short put works by selling a put option – especially one that is more “out of the money” if you are conservative on the stock. The risk of this strategy is that your losses can be potentially limitless. Since you are selling the put option, if the stock declines to near zero, you are obligated to buy worthless stock. Whenever you are selling options, you are the one with the duty to buy or sell the option. As a result, selling put options on individual stocks is generally riskier than indexes, ETFs, or commodities.
With a short put, you as the seller want the market price of the stock to be anywhere higher than the strike price. Hence, you get to keep the premium. However, unlike buying options, an increase in changes is generally bad for this strategy. In as much as time decay is generally negative for options strategies, it actually works in this strategy’s favor.
#3. Bear Put Spread
A bear put spread is often used when the investor is only moderately bearish on a stock.
To initiate a bear put spread, the investor will short (or sell) an “out of the money” put while simultaneously buying an “in the money” put option at a higher price. They both will have the same expiry date and number of shares. Unlike the short put, the loss for this strategy is limited to what you paid for the spread. This is because the worst that can happen is that the stock closes above the strike price of the long put. This will result in both contracts becoming worthless. Still, the max profits you can make also has limits.
One merit of a bear put spread is that volatility is basically a nonissue given that the investor is both long and short on the option. Also, time decay like volatility, won’t be as much of an issue given the structure of the spread.
#4. Protective Put
This is a protective put strategy allowing an investor to basically protect a long position on a regular stock.
The protective put is the best example options can being a sort of insurance for a regular stock position. For protective put, buy a put option for every 100 shares of your regular stock at a certain strike price.
If the stock price goes below the put option strike price, you will lose money on your stock. However, you’ll actually be “in the money” for your put option. Thus, you can minimize your losses by the amount that your option is “in the money.”
Buying a Put Option Example
We can also see how buying a put option works by looking at some actual examples of buying put option strategies:
#1. Say you want to purchase a long put for Oracle (ORCL) stock that is currently trading at $45. If you’re moderately bearish on the stock, you could buy a put “at the money” with a strike price of $45 per share for a $3 premium on 100 shares, that will expire in three months. Thus the total cost of the contract is $300 ($3 times 100 shares).
Given the long put strategy, $300 is the highest amount you can lose on the trade. If the stock falls to $35 per share by the expiry date, you will be $10 “in the money” on your long put. So, you’ll be making a $700 profit on the option.
#2. Another example is a short put option on Twitter (TWTR) stock trading at $30 per share. Assuming you are selling a put, of shares at a $25 strike price with a $2 premium on 100 shares. Since you are selling the option, you instantly get the $200 credit (or profit). That’s the maximum profits you can make on the trade.
However, your loss is hypothetically limitless if the stock depreciates more. Remember, a short put aims to have the contract expire worthless to pocket the premium.
Is Buying a Put the Same as Short Selling?
Both buying puts and short selling are bearish tactics, but there are several key distinctions between the two. The greatest loss for a put buyer is limited to the premium paid for the put, thus buying puts does not require a margin account and can be done with small sums of capital. Short selling, on the other hand, carries theoretically unlimited risk and is much more costly due to factors such as stock borrowing charges and margin interest (short selling generally needs a margin account). As a result, short selling is regarded as far riskier than buying puts.
Should I Buy Puts that are In The Money (ITM) or Out Of The Money (OTM)?
It is entirely dependent on elements such as your trading objective, risk tolerance, capital available, and so on. Because they allow you the right to sell the underlying securities at a higher price, in the money (ITM) puts cost more than out of the money (OTM) puts. However, the reduced price of OTM puts is mitigated by the fact that they are also less likely to be profitable by expiration. If you don’t want to spend a lot of money on protective puts and are ready to take the risk of a little decline in your portfolio, OTM puts could be a good option.
Can I Lose the Entire Premium I Paid for My Put Option?
Yes, you can lose the full premium paid for your put if the underlying security’s price does not fall below the strike price by option expiry.
I’m new to options and have minimal resources; should I think about writing puts to gain money?
Put writing is a sophisticated option technique for experienced traders and investors; tactics such as writing cash-secured puts require a large amount of capital as well. If you’re new to options and have limited funds, investing is a dangerous and not advised venture.
How to choose a broker for trading put options?
Choosing a broker for trading put options involves considering factors such as trading fees, platform features, research tools, customer support, and reputation. Research different brokers to compare their offerings, read reviews, and choose the one that best fits your investment needs.
What is the role of volatility in buying put options?
Volatility is a key factor in buying put options as it affects the price of the option. High volatility increases the price of put options, while low volatility decreases it. Understanding the level of volatility in the underlying stock is important in determining the right put option to buy.
What are the best practices for buying put options?
The best practices for buying put options include having a clear investment strategy, understanding the risks involved, diversifying investment portfolio, monitoring market trends and volatility, and regularly reviewing and adjusting option positions.
What is a synthetic put option?
A synthetic put option is a combination of a long stock position and a short call option, which provides similar benefits as a put option but with a lower cost.
How to use put options in a diversified investment portfolio?
Using put options in a diversified investment portfolio can help manage risk and protect against market downturns. By using put options in conjunction with other investment strategies, investors can potentially reduce the impact of market volatility on their portfolio.
What are the tax implications of buying a put option?
The tax implications of buying a put option vary depending on the country and jurisdiction in which the investor resides. In general, profits from put options may be subject to capital gains tax. It is important to consult with a tax professional to understand the specific tax implications of put option trades.
How to manage a put option position?
Managing a put option position involves regularly monitoring the underlying stock, monitoring market trends and volatility, and adjusting the position as needed. It is important to have a clear investment strategy and regularly review and adjust option positions to optimize investment results.
Summary
Many people think options are highly risky, and they can be if they’re put to use properly. However, investors can use options in a way that limits their risk while allowing for profit on the rise or fall of a stock.
Also, the market is volatile, as it has been recently, and investors may need to re-evaluate their strategies when choosing investments.
Buying a Put Option FAQs
Why would you buy a put option?
Traders purchase a put option to increase their profit from a stock’s drop. A trader can profit from stock prices below the strike price for a minimal upfront investment until the option expires. When you purchase a put option, you normally expect the stock price to fall before the option expires.
How do you profit from a put option?
A put option buyer profits if the price falls below the strike price before the option expires. The precise amount of profit is determined by the difference between the stock price and the option strike price at the time of expiration or when the option position is closed.
Is it better to buy or sell a put option?
Because you’re accepting an obligation to buy if the counterparty chooses to execute the option, investors should only sell put options if they’re happy owning the underlying securities at the predetermined price.
What happens if I buy a put option in the money?
An in-the-money put option has a strike price that is greater than the underlying asset’s market price. This allows them to benefit immediately if they repurchase the shares at the market price since the price of an in the money put closely reflects changes in the underlying.
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