 Buying Puts Option Strategy
The most basic option strategies involve buying calls or
puts, depending on your market view.
When you are very bearish on the market, you can buy puts
to profit from a downward movement that occurs while you
own the option. Additionally, puts can be used to balance
risk. If you are somewhat uncertain about the market, but
you feel there is a possibility for a strong downturn, you
can purchase a mixture of calls and puts to provide
balance. Buy puts on overpriced options or options on
overpriced assets. Buy calls on underpriced options or
options on underpriced assets.
Puts can also be used for hedging purposes. They can
provide insurance against a downturn in the assets you
carry.
A put is the right, but not the obligation, to sell an
asset at a specific price (the strike price), on or before
a specific date (the expiration date).
For example, suppose XXX is presently trading at $77. per
share. If you expect the price to decrease significantly
over the next couple of months, you could purchase a put
option to greatly leverage your profits from the expected
movement. Suppose that at current prices, you could
purchase a put on XXX with a strike price of $80 and an
expiration date a couple months out for about $7.00. If you
are correct and XXX trades at $65. during the couple months
while you are holding the option, the price of your option
will more than double during that time period because the
option will be priced at least $15. (anyone holding that
option has the right to sell XXX at $80., but they can buy
it at the current price of $65., yielding a $15. profit).
Although the underlying asset price decreased less than
16%, your put option on that asset increased by 100% or
more. That's the leverage that options provide.
When you buy a put, your profit potential is unlimited. No
matter how low the underlying asset price falls before
expiration of your option, you reap the profits from that
decrease. Yet, your risk is limited. If the underlying
asset price rises by $20, the most you can lose is the
price that you paid for the option. In the example above,
if XXX rises to $97, the most you can lose is the price you
paid. In this case it would be $7.00 per controlled share.
The person who sold you the option would absorb the rest of
the loss.
When we purchase puts, we generally purchase them at-the-
money or in-the-money, because it lowers our risk of losing
the premium. Although out-of-the-money options are much
cheaper and provide greater leverage, there is a greater
risk of loss. We generally buy them several months out to
provide enough time for the market to make the anticipated
move.
Options are not like stocks where you buy them and hold
them. Decay will continually erode your position and a
change in trend can evaporate your profits quickly. It is
important to set a specific target price for the option
when you initiate the position. When we reach our target,
we sell and take our profits. Beware that greed can be a
strong motivator and make you want to increase your price
target as it is rising. However, doing that can sometimes
turn a winning position into a losing position.
It is important to analyze your expectations for the
underlying asset and for the market before selecting your
strategy.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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