Buying Puts (Long Put Options Strategy)
If you have a bearish outlook on a particular stock or asset, buying puts may be a viable option to consider. This options trading strategy allows traders to purchase the right to sell shares of a stock at a predetermined price within a specific time frame. In this article, we’ll delve into the world of puts, discussing what they are, how to buy them, and the potential advantages and disadvantages of utilizing this approach.
What Is a Put?
A put is a type of options contract that gives the holder the right, but not the obligation, to sell a specific underlying asset (such as a stock, commodity, or currency) at a predetermined price (known as the strike price) on or before a specified expiration date. Essentially, buying a put provides the holder with the opportunity to profit from a decline in the price of the underlying asset. This can serve as a form of insurance or hedge against potential losses in an investor’s portfolio.
For example, let’s say that a trader believes that the stock of Company XYZ, currently trading at $100 per share, will decrease in the near future. The trader buys a put option with a strike price of $95 and an expiration date of one month from now. The premium for the put option is $3 per share.
If the stock price of Company XYZ falls to $90 per share before the expiration date, the trader can exercise the option and sell the stock at the strike price of $95 per share. They can then buy the stock at the market price of $90 per share, realizing a profit of $5 per share ($95 – $90) minus the premium paid for the option, resulting in a net profit of $2 per share ($5 – $3).
However, if the stock price rises above the strike price of $95 per share before the expiration date, the trader may choose not to exercise the option, resulting in a loss of the premium paid for the option.
How to Buy Puts
Firstly, it’s important to note that not all brokers offer options trading. If you’re interested in trading options, you should check with your broker to make sure they offer this service. Some brokers may also require you to meet certain criteria, such as a minimum account balance or level of trading experience, before allowing you to trade options.
Assuming your broker offers options trading and you meet any necessary criteria, here are some steps to follow when buying a put:
- Choose the underlying asset: Puts can be traded on a variety of underlying assets, including stocks, ETFs, indexes, commodities, and currencies. Selecting an asset involves considering factors such as volatility, liquidity, and market trends.
- Determine the expiration date: Like calls, puts have expiration dates, which are typically several months in the future. You can choose an expiration date based on your trading strategy and market outlook. Longer expiration dates will generally cost more than shorter ones, but can also offer more flexibility.
- Select the strike price: The strike price is the price at which the option can be exercised. When buying a put, you want to select a strike price that is lower than the current market price of the underlying asset. This is because a put gives you the right, but not the obligation, to sell the underlying asset at the strike price. The further the strike price is below the current market price, the more expensive the option will be.
- Evaluate the options chain: The options chain is a table that lists all of the available options for a given underlying asset. When buying a put, you want to look for options with a high delta, which measures the sensitivity of the option price to changes in the underlying asset price. Options with a delta of -0.5 or lower are generally considered to be “in the money” and may be a good choice for buyers. You should also look at the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Narrow bid-ask spreads are generally preferable, as they indicate that the market for the option is more liquid.
- Place your order: Once you have selected the underlying asset, expiration date, strike price, and evaluated the options chain, you can place your order with your broker. Your broker will execute the trade on your behalf and your account will be debited for the premium paid.
In summary, buying a put involves finding a broker that offers options trading, researching the underlying asset, using the options chain to select the best option, and placing your order with your broker.
How to Adjust Long Puts
When holding a long put option, there may be times when market conditions change, or the underlying asset behaves differently than anticipated. In these cases, there are several ways to adjust a long put position:
- Rolling the option: Rolling involves selling the current option and buying another option with a later expiration date or a different strike price. This can help extend the time frame of the position or adjust the strike price to better reflect current market conditions.
- Adding a second put: Adding a second put option to the position can create a “bear spread” or a “long put vertical spread.” This involves buying a put option with a lower strike price and selling a put option with a higher strike price. The potential profit on this strategy is limited, but it can help reduce the overall cost of the position.
- Selling covered calls: If an investor holds a long stock position and a long put position, they can sell a covered call option to generate income. This involves selling a call option with a higher strike price than the current stock price. If the stock price rises and the call option is exercised, the investor will be obligated to sell the stock at the strike price but will also receive the premium for selling the call option.
- Closing the position: If market conditions change significantly or the underlying asset behaves differently than anticipated, it may be best to close the long put position and take the loss. While this may be a difficult decision, it can prevent further losses and allow the investor to move on to other investment opportunities.
Overall, adjusting a long put position requires careful analysis of market conditions and a willingness to adapt to changing circumstances. By using these strategies, investors can potentially reduce losses or generate additional income while holding a long put position.
Pros and Cons of Buying Puts
Here are some of the pros and cons of buying puts:
- Hedging: Puts can be used as a form of insurance against a decline in the value of an underlying asset, allowing investors to protect their portfolio from potential losses.
- Limited risk: The most an investor can lose when buying a put is the premium paid for the option. This can limit their risk exposure to the underlying asset.
- Leverage: Buying puts allows investors to control a larger position in the underlying asset than they would be able to if they purchased the asset outright, potentially increasing their returns.
- Cost: Puts have a premium cost, which is the price paid to buy the option. This cost can reduce the potential returns and increase the break-even point.
- Time decay: Puts have an expiration date, and the value of the option decreases over time as it approaches expiration. This can reduce the value of the option if the market does not move as expected.
- Limited gains: While buying puts can limit losses, it also limits potential gains, as the most an investor can make is the difference between the strike price and the market price of the underlying asset.
- Complexity: Options trading can be complex, and investors must have a good understanding of the options market and how to manage risk effectively.
In conclusion, buying puts can be a useful tool for traders and investors looking to hedge against market risk or profit from a decline in the value of the underlying asset. However, it’s important to consider the potential costs, time decay, and complexity of options trading before buying puts.
The Bottom Line
In conclusion, buying puts can be a useful strategy for traders who want to potentially profit from a decline in the price of an underlying asset. By purchasing the right to sell a stock at a predetermined price, traders can benefit from a drop in the stock’s value while limiting their potential losses to the cost of the option premium.
However, it’s crucial for traders to understand the risks involved and to carefully select the underlying asset, expiration date, and strike price when buying puts. They should also be aware of factors that can impact the value of their options, such as changes in volatility and time decay.
Buying puts can be an effective way for traders and investors to hedge their existing positions or to speculate on a bearish market, but it should always be done as part of a well-diversified portfolio and with a clear understanding of the potential risks and rewards.