When an investor buys a put option, they’re hoping the value of the underlying stock decreases. They make a profit with the put when an option’s price rises, or when they exercise the option to purchase the stock at a price that’s less than the strike price. They are then able to sell the equity in the open market, the difference of which is all profit. By purchasing a put option, they limit their loss risk to only the premium paid for the put option.
Key takeaways to buying a put option
- Put options give investors a way to establish a bearish position on a security or index.
- Investors need to consider the duration of time, amount they can afford, and length of move when buying a put option.
- Buying put options is as easy as selecting an asset and choosing an expiration date and strike price.
- Buying put options is similar to buying futures contracts and short selling, however, there are also many differences investors need to understand.
What is a Put Option
Put options let investors establish a bearish position on an index or security. When an investor purchases a put option, they buy the right to sell the underlying asset at the option’s stated price but are under no obligation to buy the secured asset.
The investor must exercise the put option within the contract’s specified timeframe. If the value of the asset falls below the put strike price, the put value appreciates. Conversely, if the value of the asset remains above the strike price, the investor won’t need to purchase the asset, and the put can expire worthlessly.
Put options are especially useful for hedging the risk of declines in stock or portfolio since the worst-case scenario is losing the put premium, or the price an investor pays for the option. This happens when the drop the investor was anticipating doesn’t happen. However, even in this case, the increase in the portfolio or stock may offset a portion or all of the premium paid for the put.
Factors to Consider When Buying a Put Option
Most exchanges offer a wide range of put options with various expiration months and strike prices. This allows investors to pick a put option that meets their objectives. Factors to consider when deciding which put options to purchase include:
- How much time they plan on being in the trade
- How much money they can allocate towards the purchase of the put option
- Length of move they anticipate from the market
Duration of Time
If an investor expects an asset to finish its downward movement within two weeks, they will want to purchase a put with a minimum of two weeks remaining on it. Generally, investors don’t want options with six to nine months left if they only plan on being in the trade for a couple of weeks as the option will likely be more expensive.
Investors need to be aware that the time premium of an option, or the value of the option based on how much time remains before expiring, decays more quickly in the options last 30 days. This means they may be right about a trade, but the option may lose too much time value for them to be profitable in the end. Investors should only buy options with more than 30 days left until expiration.
The majority of futures exchanges offer a wide range of options with various expiration months and strike prices, allowing them to select an option that meets their specific goals.
Amount You Can Afford
Depending on an investor’s risk tolerance and account size, some options may be too expensive for them to purchase. In-the-money put options and options with more time remaining before expiration are more costly than out-of-the-money options with shorter expiration time periods.
Unlike futures contracts, there’s no margin when buying futures options. This means investors need to pay the entire premium upfront, so options on volatile markets such as crude oil futures will most likely cost an investor several thousand dollars. Transactions such as these may not be suitable for all investors. It’s important for investors not to buy deep out-of-the-money options just because they can afford to. Most experts consider these options long shots with most deep out-of-the-money options expiring worthless.
Length of Move
To control their risk and maximize their leverage, investors need to have an idea of what kind of move they anticipate from the futures or commodity market. Buying in-the-money options is a more conservative approach, while buying in-the-money options a more aggressive one. If a market makes a significant downward move, having several out-of-the-money options contracts increases an investor’s returns. The risk is also higher, though, with them taking a chance on losing the whole premium if the market doesn’t go down.
How to Buy a Put Option
When an investor decides to jump into the world of buying put options, they’ll discover the process is quite easier than shorting stock. Buying a put option is much cheaper, offers more leverage, and doesn’t require them borrowing shares of an asset to initiate their position.
1. Identify an Asset
Investors need to identify the asset they think will decrease in value. Let’s say an investor thinks Starbucks Corporation (Nasdaq: SBUX) will decrease in value in the next month.
2. Choose an Expiration Date
Since put options have expiration dates, investors need to decide how much time they want to buy. This decision is based on how long they plan on being in this position. Instead of just purchasing a one-month put option for SBUX, they should buy an additional month or two. It’s always safer to have more time than needed than not enough. Buying long-term options also limits the effect of time decay.
3. Choose a Strike Price
Finally, investors need to select a strike price. In-the-money put options are more conservative, making them an excellent place to start, especially for new investors. In-the-money puts have a strike price higher than the stock price. With SBUX sitting at $88, an investor could buy a two month $90 put for $2.70. Since put prices are on a per-share basis, the $90 put would cost a total of $270 ($2.70 x 100 shares). This price is also the maximum risk in this position.
Put option rewards are only limited by the underlying stock falling to a zero value. Just like with trading stocks, the objective with put options is to buy low and sell high. If SBUX takes a big enough drop, it could send the $2.70 put option to $4, $5, $6, or higher.
4. Exit the Option
After the SBUX stock has made an anticipated drop, the investor can exit the put option, hopefully with profits in tow.
Alternatives to Buying Put Options
Put options allow investors to meet specific objectives and play the market in ways they may not otherwise be able to. While other strategies like futures contracts and short selling offer similar outcomes, there are definite differences that investors need to be aware of.
Put Options vs. a Futures Contract
Unlike put options where an investor’s total loss risk is limited to the premium they paid for the option along with any additional fees, futures contracts have unlimited loss potential. Futures contracts also move in value more quickly than put options, unless the put option is deep-in-the-money. The increase in volatility makes it harder for an investor to ride out many of the ups and downs, forcing them to close the contract early to limit their risk.
Put Options vs. Short Selling
Both put options and short selling are bearish strategies investors use to speculate on an asset’s potential decline. They can also assist in hedging downside risk in a specific stock or portfolio.
Investors who short sell are basically selling assets they don’t have in their portfolio. They do this believing the underlying asset will decrease in value in the future. Investors purchasing put options are also betting the cost of an asset will decline in the future and state a price and timeframe they will sell that asset at.
Experienced investors look at many factors when deciding between short selling and buying put options, including if the trade is for hedging or speculation, cash availability, risk tolerance, and investment knowledge.
While buying put options and options trading can be very lucrative, they also carry risks that investors need to be aware of. Jeff William’s free Profit Prism Small Account Starter Pack gives investors the tools needed to understand investment strategies and grow their accounts.