4 Tips on Buying Put Options
My next post in the Stock Options Trading Series will focus on put options tips. There is a lot of discuss about long calls & puts, so we will ignore the more advanced options trades for a while. Here are 4 tips on buying using my recent purchase of Amazon Inc. (AMZN) put options at a strike price of $47.5 as an example.
1. Safeguard Your Holdings, and Invest Your Spare Money
In order to fund this investment, free up some cash from another account other than your stock portfolio, mutual fund portfolio, or IRA account. I funded the ZQN SW (AMZN 47.5 Puts) with spare cash from my checking account. Buying puts places a lot of risk on your investment because options prices tend to move extremely fast.
While you may only lose your initial investment, you still may endure a financial loss (or as I call it, a business expense). Therefore, investing your discretionary funds is a good idea. Risk your screw around money, and leave your existing investments alone.
2. Put Stocks With Aggressive Price Movement
Note: This is one of many put options methods available at your disposal.
Amazon posted a strong Q1, and AMZN stock rallied on April 24th by gaining 16 points since the earnings release. Now, Amazon shares are overvalued in my opinion.
The company still copes with a negative retained earnings deficit, and the P/E ratio stands at 102. Along with the current bull market, AMZN stock ignited, but I believe Wall Street will extinguish the fire once the bears take control.
Amazon looks like the perfect short play. One of my newly adopted put strategies is to bet against overvalued stocks with aggressive price movement. If the price moves up quickly, then the downward may follow close suit.
3. Give Your Options At Least 3 Months Until Expiration
My Amazon puts had 75 days until expiration when I purchased them. 75 days was the perfect time frame in terms of my analysis and cost, however, 3 months gives you an extra 15 days to profit from the market. Timing, along with at least 3 months of cushion days until expiration, greatly affects your profit earnings potential.
To serve as an example, I bought AMZN puts set to expire in July because the month of July serves as the middle month between the beginning of the summer and the end. Since Amazon will surely experience strong sales during the Back to School scramble, July appears to be the optimal month for sluggish retail sales. As long as Amazon stock depreciates in value before the end of July, I will make some money on the puts.
Unless you’re an expert at day-trading Stock Options, giving your options time to move towards In-The-Money will save you pain and agony in the future, and accelerate your gains.
4. Think Objectively!
My first put trade was a disgraceful decision made with zero reasoning or sanity. I was emotional. And I lost money.
What’s the moral?
Eliminate your emotions, and either make or cancel the trade. Letting your emotions dictate your course of action is like handing your wallet to Wall Street and running in the other direction. Another trader will take your money, and never offer it back. So make it easy on yourself, and think objectively, not subjectively. The Amazon trade made sense, so I placed it. If every options trade turns into a game of 20 questions, just stop altogether.
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May 11th, 2007 at 7:14 am
Great post- I got way too excited about some May $52.50 puts a day or so after Amazon announced. In the house of pain on those. I’ve stuck to calls in the past and most likely will do so in the future- just fits my strategy better.
May 11th, 2007 at 8:24 am
Good point, AMZN stocks should experience a little downside in the summer, now is the time to buy puts!
May 11th, 2007 at 8:54 am
@ Lucas
I feel the same way about Calls. I’ve had better luck identifying undervalued stocks than overbought stocks. It’s easier to pick out “uncovered gems” because they are sometimes so cheap and forgotten about.
I’m thinking puts because the bullish Dow trend has got to end. Seriously, when will we see a correction?
May 11th, 2007 at 8:59 am
Hate to nitpick an otherwise good post, but what’s the deal with saying Amazon gained 16 points after the earnings. It makes it seem so abstract (like an index). Call it for what it is: US dollars; you’re loosing (or earning) them. When you use the word points it feels the same as how casinos have you use chips instead of money in order to make you forget about all the money you’re loosing.
-Brian
May 11th, 2007 at 9:05 am
Hahah. Casinos and the stock market have more similarities than we know about. But I get what you mean. I probably sound like those obnoxious market pundits on CNBC.
Also, good point on the clever casino terminology. We could all learn a thing or two from the casino industry.
May 12th, 2007 at 6:29 am
TJP,
Nice series on options trading. Good luck on your AMZN puts.
In my experience, I have made the most money on selling puts and calls. I think 80% of options expire worthless, which is in the favor of the options writer.
May 12th, 2007 at 11:09 am
@ Super Saver
Actually 60% of options contracts are sold back into the marketplace, 10% of options contracts are exercised, and the remaining 30% expire worthless.
Do you sell naked calls and puts? or do you cover yourself with the backup cash?
May 13th, 2007 at 6:30 am
I sell naked puts. I think your point #3 is the most important one for put buyers. I only sell 1-2 months out where time decay makes the most money for me. Buying 3+ months out can be all it takes to flip the advantage to the buyer.
May 16th, 2007 at 4:09 am
TJP,
I thought I had replied already. Apologies if this comment is a duplicate.
I sell naked puts on stocks which I am will to have long postions. I have cash backup, if the options are exercised. I consider naked calls too risky.
Thanks for the clarification on options results. I don’t recall where I saw the data. Looks like about 75% of options that go to expiration become worthless. I didn’t know that 60% of positions were closed out before expiration.
May 16th, 2007 at 9:41 am
Here’s the CBOE data on the percentage of worthless options. More investors make money by buying the options low and selling them high, rather than using the contracts to enter a stock position.
May 16th, 2007 at 5:38 pm
TJP, Thanks for the link on worthless options, that’s cool. Where did you hear that more investors make money buying options low and selling them high? I would think the number would be fairly even either way considering that every call that increases in value has a put that decreases in value, taking out volatility, etc.
Throw in time value and I’d think more would decrease in value on both sides.
I agree Super Saver and I are in the minority with entering positions this way instead of just trading options.
May 16th, 2007 at 5:59 pm
TJP,
Thanks for the link. I guess it’s a common misperception on the number of total options that expire worthless. Glad you provided me the correct info.
Anecdotally, I agree with your point on making gains on options. In 1998, I doubled down on a losing postion on INTC Jan 1999 leaps. In October, 1998 the Jan 120 Leaps were $0.25 and INTC was $70. INTC rose to 125 ish before the expiration date. I sold the leaps at $3, $4 and $5 dollars. Wish investing were always this easy and profitable:-) To note, this was an abnormal win for me.
May 16th, 2007 at 7:18 pm
Most people miss the boat by not investing money that’s safe. They put all their eggs into it and then get so disappointed when it doesn’t work they quit investing.
May 18th, 2007 at 1:54 pm
@ The Trader
With every winning trade, there is a loser of course. But for experienced options traders, they have a concrete trading system, and know how to make money from profitable trades, and when to ditch the losers.
I didn’t mean that everyone makes money. I guess I should have said “the experienced traders make money.”
Also, I am beginning to sell puts to enter positions as well. You and Super Saver implement a very smart technique that I wish to utilize.
P.S. Time value really hurts on the losing puts!
@ Super Saver
Excellent trade! Leaps can make you a lot of money. Any thoughts on Apple 2008 Leaps? The iPhone releasal is going to be huge in my opinion.
May 27th, 2007 at 5:19 pm
TJP,
While I think AAPL is a good stock, the leaps have too high a premium for me to buy them. At this point, I also think the stock may be overpriced. My stock picking system has recently identified AAPL as an “almost buy.” However, I probably will not buy it in near future, since I think other buys will have more potential for gains.