More specifically, it’s a contract that provides the buyer (of the option) the right to sell a designated quantity of shares at an agreed price and by a specified date.
What is a put option? A put option:
- is a contract that gives the holder the right to sell an underlying security, such as a stock, at a pre-determined price, which is called the strike price,
- must be executed within a specified time frame, and
- does not oblige the owner to sell, but rather gives her the right to decide to do so during the contract period.
Conversely, a call option is a contract that gives the holder the right to purchase the underlying security.
Think of Put Options like buying insurance for your iPhone. It costs you a premium to protect your phone.
However, if the phone breaks, you’ll be covered. On the other hand, if you are not “hedged” then you could end up spending a lot more to get a new phone if it breaks.
It’s all about risk vs. reward. That said, when you buy a put option, or put options, it’s considered a bearish strategy.
That is, you’ll profit if the underlying stock drops in price. However, if you buy a put option and you are holding the underlying stock, it’s considered a hedge.
What is a Long Put Option?
If you’re bearish on an underlying asset, you might consider a long put option. A long put means buying a put option to make a bet that the underlying asset will fall. An investor could also use a long put to hedge a long position by offsetting the potential loss in an underlying asset.
Analyzing A Long Put Option
On January 24, Canada Goose (GOOS), got downgraded by Wells Fargo, citing that risk/reward was no longer compelling.
Shares closed lower 7.25% after the morning downgrade.
Now, let’s assume you agree with the research and feel that Canada Goose will take some heat and sell off more. So, you pull up an options chain and take a look at the Feb options, expiring in 22 days from now.
The put options are on the right. If you look up, you’ll see that shares of the stock closed near $46. That said, the $46 puts, expiring are going for about $4 in option premium (the bid/ask spread is $3.80 by $4.10).
Now, what does that mean?
Analyzing Break-Even On a Long Put Option Trade
If you buy the $46 put options, you are spending $400. Every option contract represents 100 shares ($4 x 100).
According to this position, you’ll make money if GOOS shares decline below $46 between now and expiration which is 22 days away.
However, since you are spending $4 in premium, you need to make up for that cost to break-even.
To get your break-even point, take $46 and subtract it by $4, and you get $42. In other words, You’ll need the stock to decline about 8.7% to break-even, between now and the Feb 15 expiration.
Does The Stock Always Need To Get To The Strike Price?
It is a tricky question to answer.
Let’s assume you bought $46 puts today at $4, and tomorrow the stock drops 2 points and is trading at $44, you’ll be profitable on the trade. However, if it stays at $44 at expiration, the option would be worth $2, and since you spent $4 on it, it would be a $2 loser.
Not only that, since this option expires in-the-money, you’ll be assigned the stock short the following trading day.
That’s right, and if you are long a put option that is at least one penny in-the-money, then it will be exercised.
However, let’s say you don’t have the funds to convert options into stock, typically your broker will send you an email or message alerting you. If you don’t act, they’ll usually get you out of the position. They do this to protect themselves and you.
Of course, you’re never locked into a long option trade, puts or calls. You can always close out for a profit, loss, or break-even.
When Should You Buy A Put Option
That said, two of the most critical factors that influence an options price, is time and volatility. Keeping all things equal, the farther out you go out it in time, the more expensive options are. Furthermore, the higher the options volatility, the more expensive options are.
So what causes option volatility to spike?
It’s all about supply and demand. For example, let’s say share prices are crashing because it got attacked by a short-seller report. If you are long the stock, you might buy puts to hedge the position.
Most likely, a lot of longs will too. You see, it takes time to verify the report. If it turns out to be true, the stock could decline even more.
That said, traders are scrambling to buy puts, driving the price higher. Of course, speculators are buying puts to profit off from its price decline, adding fuel to the fire.
For example, let’s assume that Wayfair (W) is trading at $100 per share. Check out the price of the $100 put options with 120 days till expiration, and at different volatility levels.
- 15% implied volatility, options priced at $3.28.
- 30% implied volatility, options priced at $6.72
- 60% implied volatility, options priced at $13.56
Don’t Make This Mistake
See, this is why a lot of rookie options traders lose. They fail to take into account the volatility factor. Just because you buy puts and the stock drops, it doesn’t always mean instant profits.
Sorry, that’s not how this works.
That said, when you buy a long put option, you also capitalize on implied volatility spikes. On the other hand, a decline in volatility will hurt a long put option position.
For example, during earnings, options implied volatility would elevate because of the uncertainty.
However, after the company announces, the risk is gone. At that point, the market players try to decide whether the information is bullish or bearish for the company.
There are ways around it, like buying spreads, a slightly more advanced strategy that I’ll teach later.
The best way you can tell if options are expensive or not is to compare it to the past. For example, on January 24, Tesla (TSLA) options had an implied volatility (30-day average) of 71.6%
Now, is that a lot?
It’s 52-week low implied volatility is 35.1% and its high is 86.9%. Further, its 71.6% implied volatility is at the 93rd percentile. This information is found in most brokerage platforms.
Put Options Trading – Our Final Thoughts…
Buying put options allow you to make money when stocks are dropping. Also, they can be used to hedge your portfolio.
For example, if you think the market looks weak, you could try to buy SPY, DIA, QQQ, or IWM puts.
On the other hand, any spikes in implied volatility will make long puts jump in value. Now, if you want to learn more about how to buy put options, and how you can become a better trader, check out my eBook.