Want to bet against the future of a company or index? A put option is one way to do so. It gives the owner of an option contract the ability to sell at a specified price any time before a certain date. It can be a good way to hedge against declines, but it comes with a bit of risk. You can lose not only what you invested, but even more than you realized.
A Put Option Explained
Buying a put option gives you the right to sell a stock at a certain price the strike price any time before a certain date. This means you can require whoever sold you the put option the writer to pay you the strike price for the stock at any point before the time expires. However, you are under no obligation to do so.
Buying put options is a way to hedge against a potential drop in share price. They could also reap profits from bear markets or declines in the prices of individual stocks.Risk of Put Options
Options are derivatives, meaning they derive their value from an underlying security. Trading in derivatives can be more complicated and risky than buying and selling stocks and bonds.
Depending on the type of derivative, losses can be much more than the amount invested. In a worst-case scenario, losses for some derivatives can be nearly limitless.Hedging With Put Options
One use for put options is to hedge against a possible drop in your portfolio’s share prices. Say you own 100 shares of a stock valued at $100 per share. You are concerned that the stock could fall to $90 over the next three months.
You could buy a put option giving you the right to sell 100 shares of the stock at a strike price of $100 at any time in the next three months. Since you own the shares, this is called a covered option.
Option prices vary, but say this one costs $2 per share. That’s $200 for a standard lot of 100 shares.
If the stock falls to $90 or lower during that period, you could require the writer of the option to buy your shares for $100 each. This would prevent you from losing any more than the $200 cost of the option.
If the three months passes without the shares falling below $100, you would let the option expire without exercising it. You would have spent $200 without gaining anything but peace of mind.Buying Uncovered Put Options
You can also buy put options for shares you don’t own. But you have to buy the shares before exercising the that uncovered put option.
You can buy put options on indexes as well as individual securities. This can produce profits from broad declines in bear markets.
If the price of the optioned shares in the earlier example fell to $90, the buyer of an uncovered put option could still require the writer to purchase 100 shares for $100 each. First, he or she would purchase the shares for $90 each. After paying the $200 option premium, this put option would earn $800.
Of course, the share prices might not decline below the strike price. Then the put option buyer would let the option expire unused. The $200 would have been spent for no gain.
Buying uncovered put options gives an investor lots of leverage. In this example, the investor controls shares worth $10,000 at a cost of only $200. That $200 is also all the investor has at risk.
However, the profit potential in this example is as high as $10,000, or $9,800 after the $200 option premium, should the shares drop to zero in value.How to Buy Put Options
To buy put options, you have to open an account with an options broker. The broker will then assign you a trading level. That limits the type of trade you can make based on your experience, financial resources and risk tolerance.
To buy a put option, first choose the strike price. This will normally be somewhat below where the stock is currently trading.
Next choose an expiration date. This could typically be from a month to a year in the future. Longer time periods generally mean less risk.
Next decide how many contracts to buy. Each options contract is for 100 shares of stock. For each contract you will pay the listed premium for that option, plus brokerage fees.
After paying, watch stock prices to see if it’s time to exercise the option. You can exercise the option at any time before the expiration date.
If current prices fall below the strike price, the option is considered in the money. If your option is in the money, you can require the writer of the option to purchase your shares at the higher strike price.
If the stock price doesn’t decline, you can let the option expire. You won’t make anything but your losses will be limited to the option costs and fees.Bottom Line
Buying put options can be a simple and less risky way to trade options. Put options can hedge portfolios and produce profit during falling markets. But it’s important to learn how they work and make sure you can withstand losses before buying put options.
If you aren’t sure what trading level you’d meet or how much risk you’re willing to take on, it may be time to talk to a financial professional. They can help you figure out those details and weigh the benefits and risks of put options against similar alternatives.Options Tips
Photo credit: iStock.com/woraput, iStock.com/vm, iStock.com/damircudic
Information contained on this page is provided by an independent third-party content provider. Frankly and this Site make no warranties or representations in connection therewith. If you are affiliated with this page and would like it removed please contact firstname.lastname@example.org