Put options are versatile financial instruments that can be used for various investment strategies. Understanding when to buy puts requires a thorough grasp of their mechanics and the potential benefits they offer. This comprehensive guide delves into the intricacies of put options, exploring their applications and optimal scenarios for their use
Understanding Put Options: A Primer
A put option grants the holder the right, but not the obligation, to sell a specific underlying asset (e.g., stock, bond, index) at a predetermined price (strike price) on or before a specified date (expiration date). The buyer of a put option pays a premium to the seller for this right.
The value of a put option is inversely proportional to the underlying asset’s price. As the underlying asset’s price decreases, the put option’s value increases and vice versa. This inverse relationship makes put options ideal for investors who anticipate a decline in the underlying asset’s price.
When to Consider Buying Puts
Several scenarios warrant consideration of buying put options:
1. Hedging Against Downside Risk:
Put options can serve as a protective hedge against potential losses in an existing portfolio. By purchasing a put option on a stock you own, you effectively limit your downside risk. If the stock price falls, the put option’s value will increase, offsetting some or all of your losses.
2. Speculating on a Market Decline:
If you believe a particular stock or the broader market is poised for a decline, buying put options can be a way to profit from that anticipated downturn. As the underlying asset’s price falls, the put option’s value increases allowing you to sell it at a profit.
3. Generating Income:
Selling covered puts (selling a put option while owning the underlying asset) can generate income in the form of the premium received. This strategy is suitable for investors who are bullish on the underlying asset and are comfortable with the possibility of being assigned (obligated to buy or sell the underlying asset).
4. Achieving a Specific Purchase Price:
If you want to buy a stock at a specific price but believe it is currently overvalued, you can sell a cash-secured put. This strategy involves selling a put option and setting aside the cash to buy the underlying asset if the put is exercised. If the stock price falls to or below your desired purchase price, you will be assigned the stock at the strike price, effectively achieving your target purchase price.
Key Considerations Before Buying Puts
Before buying puts, carefully consider the following factors:
1. Market Volatility:
Put options are more valuable in volatile markets, where the underlying asset’s price is more likely to fluctuate significantly. In less volatile markets, put options may not offer as much potential for profit.
2. Time Decay:
The value of a put option decays over time as the expiration date approaches. This means that the closer the option is to expiring, the less valuable it becomes, regardless of the underlying asset’s price movement.
3. Strike Price Selection:
The strike price you choose will significantly impact the cost of the put option and your potential profit or loss. Selecting a strike price too far out-of-the-money (significantly below the current market price) will result in a lower premium but also a lower chance of the option expiring in-the-money. Conversely, selecting a strike price too close to the current market price will result in a higher premium but also a higher chance of the option expiring worthless.
4. Risk Tolerance:
Buying puts involves the risk of losing the entire premium paid if the option expires worthless. Therefore, it’s crucial to assess your risk tolerance and invest only what you can afford to lose.
Put options offer a valuable tool for investors seeking to hedge against downside risk, speculate on market declines, or generate income. However, understanding when to buy puts and carefully considering the factors involved is essential for making informed investment decisions. By thoroughly analyzing market conditions, volatility levels, and personal risk tolerance, investors can leverage put options to enhance their investment strategies and achieve their financial goals.
Selling vs. Exercising an Option
As exercising an option will result in a loss of time value, increased transaction costs, and additional margin requirements, most long option positions that have value before expiration are closed out by selling instead of exercising.
Example of a Put Option
Assume an investor buys one put option on the SPDR S&P 500 ETF (SPY), which was trading at $445 (January 2022), with a strike price of $425 expiring in one month. For this option, they paid a premium of $2.80, or $280 ($2.80 × 100 shares or units).
The $425 put will be “in the money” and trade at least $10, the put option’s intrinsic value, if SPY units drop to $415 before it expires. e. , $425 – $415). The time till expiration is the primary determinant of the put’s precise price, though other factors also play a role. Assume that the $425 put is trading at $10. 50.
The investor must choose between (a) exercising the put option, which would grant the right to sell 100 shares of SPY at the $425 strike price, and (b) selling the put option and keeping the profit because it is now “in the money.” We examine two scenarios: (i) the investor currently owns 100 SPY units; and (ii) the investor has no SPY units. (The calculations below ignore commission costs, to keep things simple).
Let’s say the investor exercises the put option. If the investor’s portfolio already contains 100 SPY units (let’s say they were bought for $400), and the put was acquired to protect against downside risk, then e. the investor’s broker would sell the 100 SPY shares at the $425 strike price (it was a protective put).
The net profit on this trade can be calculated as:
The number of shares or units is equal to [(SPY Sell Price – SPY Purchase Price) – (Put Purchase Price)].
Profit = [($425 – $400) – $2. 80)] × 100 = $2,220.
In the event that the put option was bought solely as a speculative trade and the investor did not own the SPY units, exercising the put option would result in a short sale of 100 SPY units at the $425 strike price. The investor could then terminate the short position by purchasing the 100 SPY units back at the $415 market price.
The net profit on this trade can be calculated as:
The number of shares or units is equal to [(SPY Short Sell Price – SPY Purchase Price) – (Put Purchase Price)].
Profit = [($425 – $415) – $2. 80)] × 100 = $720.
It sounds like a fairly involved process to exercise the option, sell the shares (shortly), and then buy them back, not to mention additional expenses like commissions (because there are multiple transactions) and margin interest (for the short sale). However, the investor really has a simpler “option” (for want of a better term): just sell the put option at the current price to profit handsomely. The profit calculation in this case is:
[Put Purchase Price – Put Sell Price] × Total Number of Units or Shares = [10 50 – $2. 80] × 100 = $770.
There’s a key point to note here. Selling the option actually yields a profit of $770, which is $50 more than the $720 earned by exercising the option, as opposed to having to go through the somewhat complicated option exercise process. The time value of $0 is enabled by selling the option, which is why there is a difference. 50 per share ($0. 50 × 100 shares = $50) that should also be recorded As a result, rather than being exercised, the majority of long option positions that have value before expiration are sold.
The maximum loss on an option position for a put option buyer is restricted to the put option premium. The option position’s maximum gain would happen if the price of the underlying stock dropped to zero.
Put Options Explained: Options Trading For Beginners
FAQ
Is buying puts a good strategy?
Is it better to buy puts or sell short?
Why would I buy puts?
What is the downside of buying puts?
When should you buy a put option?
An investor would buy a put option if they expected the underlying futures contract price to move lower (decrease by the sell date). For example, if you buy a United States 12 Month Oil Fund (USL) July 22 put, you’re purchasing the right to sell the contract at $22 (your “strike price”) before July.
When are put options in the money?
Put options are “in the money” when the stock price is below the strike price at expiration. The put owner may exercise the option, selling the stock at the strike price. Or the owner can sell the put option to another buyer prior to expiration at fair market value.
What happens when you sell a put option?
When you sell a put option, you’re placing a bet that the value of the underlying stock will increase or stay the same value over the course of the contract. For a put buyer, if the market price of the underlying stock moves in your favor, you can elect to “exercise” the put option or sell the underlying stock at the strike price.
Are put options a good investment?
A put option allows investors to bet against the future of a company or index. More specifically, it gives the owner of an option contract the ability to sell at a specified price any time before a certain date. Put options are a great way to hedge against market declines, but they, like all investments, come with a bit of risk.