By trading put options you actually make more money. Stocks fall faster and harder than they rise. Continue reading to learn the secret to making money when stocks fall in price.
As we talked about in the earlier lessons, put options allow you to potentially sell something for MORE than it's worth.
The buyer has the right, but not the obligation, to sell shares of a stock at a specified price on or before a given date.
So let's look at how this plays out with a real stock trade.
Put options give the 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", 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 3rd 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 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 options contract 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's "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.
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 option contract 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.
Module 3: Basic Strategies