Buying Put Options

Module 3: Basic Strategies
Lesson 4: Buying Put Options

Buying Put options are how you make money when stock prices are falling.

Most investors watch the stock market fall and grumble about how much money they are losing. During these times, dollar cost averaging doesn't seem to soothe the soul.

Before I became an option trader I used to get tired of watching stock prices fall and feel like there was nothing I could do about it. Buying Put options completely eliminates that helpless feeling.

You feel more in control because you are able to make money on the way down.

Buying Put options are a way to profit from a downturn in the stock market without shorting the stock. Short selling is beyond the scope of this lesson however if you understand the concept of shorting stocks it will help you to understand the power of Put options.

In the previous two lessons we discussed how Put options are used as a hedge (insurance) against a decline in stock price. This lesson focuses on yet another use, buying Put options to trade them for a profit.

You are going to buy Put contracts that you think will increase in value. Once they do increase in value you will sell them at a higher price and pocket the difference.

Buying Put Options

Buying Put options should not be confused with Married Puts or Protective Puts. Married and Protective Puts are purchased to protect shares of stock from a sharp decline in price.

The major difference between buying Put options and Married/Protective Puts is that there is no ownership in stock. Buying Put options involves just that, buying only the Put option.

When you buy only the Put option it completely changes the dynamics of the trade. You want the stock price to fall because that is how you make your profit.

In "most" cases you never intend on exercising your rights to sell the stock. You just want to benefit from the movement of the stock without having to own the stock, and you can do this with Put options.

Example of Buying Put Options

A Put option gives its buyer the right, but not the obligation, to sell shares of a stock at a specified price on or before a given date.

For instance if you bought an IBM January 130 "Put option", the option (contract) gives you the right to "sell" IBM stock for a price of $130 on or before the third Friday of January.

If IBM falls below $130 before the 3^rd Friday in January you have the right to sell the stock for more than its market value.

So let's say that IBM falls in price to $76. Everyone else who owns the stock has to sell it for $76, but you own a contract that says you can sell it for $130! You hold a contract that says you get to sell something for more than its market value.

Someone who owns a great deal of the stock and is facing the pressure of selling it at $76 would love to own a contract that says they could sell it for $130.

Do you think they might be willing to buy that contract from you? Yup they sure would.

Now can you see why Put option contracts go up in value as the underlying stock goes down in price? The further the stock falls below your strike price ($130), the more valuable the option becomes.

Let's pretend that IBM was trading at $200 a share. Your Put option would not be as valuable. Who would want to buy a contract from you that gives them the right to sell the stock for $130 when they could easily sell it for $200 a share on the open market?

No one, which is why Put options decrease in value as the stock price rises.

So when an individual believes that the price of a stock is going to fall, they can profit from this movement by purchasing a Put Option. You can cash in by either selling the Put at a profit, or by exercising the option and then selling the stock.

Closing Out the Position

Using the option's actual historical prices here is how the IBM trade would have looked if a trader decided to sell his/her Put:

The amazing part about this example is that these are the actual prices from the option chain. These are also the kinds of trades that make me sick to my stomach because I discover them after the fact.

Since the Put option is in-the-money (ITM) another choice would be to exercise the option:

As you can see in the example, the profit is the same whether the option is traded or exercised. Another point to note is that when an option is in-the-money (ITM), its option price "generally" moves dollar for dollar with the stock price movement. This applies for both Puts and Calls.

The percentage returns are different because in the first example you only had to risk or commit $900 to make $5,400, but in the second example you had to risk or commit $7,600 to make the same $5,400.

Advantages of Buying Put Options

• Allows you to participate in the downward movement of the stock without having to own or short the stock
• You only have to risk a relatively small sum of money to buy a Put Option
• The maximum amount you can lose on a trade is the cost of the Put
• Leverage (using a small amount of money to make a large sum of money)
• Higher potential investment returns

Disadvantages of Buying Put Options

• The Put option has an expiration date so time works against you
• The stock has to make a move downward in order for the Put option to increase in value
• If the stock stays flat or doesn't move, then the Put option will lose value due to time decay

You can proceed to Module 4: Stock Charts whenever you feel you are ready.

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