In the last part of options trading series, we talked about long call options, and how investors buy them to profit from bullish stock trends. Now, we'll take a look at the inverse of call options, put options.
What Are Put Options
You make money on puts when the underlying stock price falls. The easiest way to define puts is to compare them to shorting stocks, except the risk is a lot less. So in a nutshell, put options allow you to profit from depreciating stock prices for a fraction of the shorting costs.
Long Put Options Diagram
Much like call options, there are 3 keys characteristics to understand:
- Break-Even Point
- Strike Price
- Movement in Underlying Stock
These concepts were quoted and altered to match put option characteristics.
1. Options Strike Price
I defined options strike prices in my last post, but so I won’t spend too much time on this concept. It’s simply a fixed price level on the underlying stock, comparable to a watermark in a bucket.
2. Options Break Even Point
This refers to the point where the value of your options depreciates in equal value to your purchase premium and may become profitable (i.e. ITM or in-the-money options). When your options reach the break even point, you’ve placed a profitable options trade. Unless the underlying stock moves downwards rather quickly, your trade is out-of-the money, meaning the trade has no intrinsic value and negative value. Another way to view the break even point is simply the strike price minus the premium you paid for the options.
3. Relationship between Stock and its put options
This concept may confuse you at first, but there are Greek options concepts which determine the relationship between a stock’s value and the value of its stock options. I won’t dig into the Greeks yet, because that’s a whole different blog post. But it’s important to grasp that your put options become more profitable as the underlying stock decreases in value.
Although time value, the days between the options expiration date and the current date, degrade an options value over time, it’s best to buy long put options at least 3 months in advance to avoid time-value losses. As the expiration date nears, and especially within 30 days, the value of your call options depreciates rapidly.
Benefits of Long Put Options
Limited Risk, Limited to Zero Reward
Maximum Risk: Limited to Premium Paid
Maximum Profit: Limited to gap between Strike Price and Zero
Whenever you buy long puts, your risk is limited to the premium paid for the options. You will maximize your gains if the stock price falls to zero because then your options possess a lot of intrinsic value that may be redeemed once you sell. As long as you buy puts, your risk-taking is protected.
Selling puts is different. Your upside is limited to the premium received, but your downside equals the dollar gap between the strike price and zero. I wouldn't advise selling puts unless you're desperate for income or want to open a long position. No speculation here! It's really dangerous, and has ruined families and lives time after time.
The Signapore student who lost $300k in 3 months was an options gambler. He sold puts and bought volatile stocks, but the puts really hurt him.
Profit From Overvalued Stocks
Put options is how corporate executives and hedge fund managers make so much money when stocks dive in value. They buy put options to protect their profits, and make money once a stock's bullish run is over.
Now is the perfect time to get familiar with stock options. The Dow Jones Industrial Average is peaking at an all-time high. So many stocks on my watchlist are grossly overvalued; it's disgusting.
This is your opportunity to make some real money once the Dow correction hits. If you play your cards right, put options could make you a lot of easy money because you anticipated the stock market fall. On May 4th, I watched Yahoo! options soar 1400% in 3 hours. Just as quickly as shares rise, they can fall as well.
Closing Thoughts on Put Options
Put options are so vital to the average investor/trader. There is no other way to gain favorable returns from bearish stock moves unless you short a stock and risk the full assessed share value in the process. Now, we've discovered another way to make money in the market. Put options will change the way you think about common shares.
Instead of searching for winners all the time, you will begin to search for losing stocks, too. 🙂 Because of put options, you can make money in the stock market no matter which direction it heads. Once you internalize this key piece of information, you will unlock another powerful key in your life.
You owe yourself extensive education on put options even though I may not explain the exact specifications in the best manner. Heck, I'm still learning about them, too. So here's some additional reading on put options. Get educated, and get active!
Additional Reading on Put Options
- Writing Put Options to Acquire Stock – This is a must read!
- Wikipedia Put Options Definition – With Mathematical Equations included!