Friday, 23rd July 2010

Buying Puts

Written by George Traganidas Topics: Options, Wealth Building

Buying a put gives you the right to sell the underlying stock at a set price (the strike price) by a specified date (the expiration date). Your maximum loss with a put is limited to what you pay for the option up front (the premium).

Buying put options is a great way to profit from a stock’s fall while putting less of your cash at risk. In addition, you can buy puts to protect a stock – one that you’re bullish on for the longer term – from a near-term price drop. Buying protective puts can also help make your portfolio immune to a market crash.

When you buy a put to protect a stock that you own, your maximum profit occurs through stock appreciation. In the best case scenario, your stock appreciates nicely, and your put expires worthless – essentially, the option premium you paid is like paying an insurance premium – and like insurance, that isn’t money wasted. What you purchased was peace of mind. Theoretically, your profit is unlimited because a long stock position’s profit is unlimited. But in practice, your profit will be reduced by the premium you pay.

A put has a firm expiration date, and unless the stock’s volatility greatly increases, the underlying put experiences “time decay” – a reduction in value with the passage of time. This means that unlike a short seller, as put buyers, we can’t just sit and wait around forever.

An options strategy’s break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. To break even when buying married puts, the stock just needs to appreciate by the amount of the option premium we paid. For example, a $50 stock would have to increase $11.20, to $61.20.

Why buy puts?

  • You believe a stock is ripe for a fall and want to profit if it declines.
  • You want to hedge against the bullish positions in your portfolio.
  • You want to protect a position in your portfolio that you’re bullish on from a near-term downward move.

Which Put To Buy?

If buy a put to short a stock:

  • The put should be on a business that (1) you know well, (2) you have good reason to believe is going to fall in price precipitously, and (3) has a downside catalyst that should help it achieve your fair value estimate prior to the option’s expiration date.
  • When choosing an expiration date, make sure to allow enough time for your downside catalyst to pan out. These things sometimes take longer than expected, so it can be wise to use options that expire as far out as possible.
  • To manage your risk, start off small. Your risk is limited to the premium you pay, but if you’re wrong, you will likely lose most if not all of the premium invested in most outcomes. Only purchase enough contracts to cover the same number of shares you’d be willing to short. For example, if you’d be shorting 300 shares, stick to just buying three puts.
  • When it comes to strike prices, you have two choices: Buy an in-the-money put (usually 10% to 20% above the current share price) that will cost more, but is more likely to have value remaining at expiration. Or you can buy an out-of-the money put (with a strike price below the current share price) that will cost less, but that increases your odds of losing your whole investment if the stock doesn’t fall. Use whichever strategy you’re more comfortable with in each case.

If buy a put for stock protection:

  • the put should be on a business you know well and have good reason to believe is worth much more. However, it has enough potential near-term risk that you also want protection while owning the stock.
  • You must be willing to sacrifice the insurance premium in exchange for some extra peace of mind.
  • When deciding on the strike price, you should do so based on (1) the stock’s valuation and the potential upside you see in the shares, (2) the amount of possible risk you see in the shares, and (3) the amount you’re willing to comfortably spend for protection (which will relate in part to the upside you’re trying to capture and the downside you’re exposed to).
  • When choosing an expiration date, think in terms of purchasing insurance. Buy protection that covers enough time that will make you feel comfortable, but make sure you double-check the break-even point to make sure that there is enough upside for the overall investment to still be attractive.

Buying puts is the most direct option strategy to potentially profit on a stock you believe is ripe for a sizable decline. The strategy works best if you expect the stock to fall far within a defined time frame. Buying puts can reward you with significant upside while greatly limiting your downside compared with just shorting a stock outright. Buying puts to protect your stock is a good strategy to help you sleep at night when you don’t mind paying extra for some peace of mind. This strategy can reward you by protecting you from the downside risks while still maintaining the attractive return characteristics of investing in common stocks.

Follow the practical way,
George Traganidas

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