Option Trading Strategies such as the Long Put (buying Put Options) involve an investor buying a Put Option in order to profit from a downward move in the underlying share price. Therefore, their view on the underlying stock is Bearish.
Before executing any bearish Option Trading Strategy, it is important you thoroughly understand the fundamentals about buying and holding Put Options.
How Does a Put Option Work?
Put Options are contracts over shares that give you the right, but not the obligation to sell a parcel of the related shares, at an agreed price anytime before the contract expires.
The agreed price is called the ‘Strike price’ and you can ‘exercise’ your right to sell the shares for this price at anytime throughout the life of the option. Of course you will pay a premium, or fee to own a Put Option, however, all options cost just a fraction of the shares they relate to.
As the share price falls in value, the related Put Option actually increases in value.
When Would You Buy a Put Option?
Although Put Options can be used with Option Trading Strategies such as the Protective Put to hedge or insure shares you own, you can actually buy Puts without even owning any shares at all.
You would do this when you were looking to profit from falling share prices using just a small amount of your own capital. In other words, you would be using Put Options for leverage in order to create an income.
An example would be if you had a bearish view on a stock that was trading at say $ 20. Even though you don’t own any of the related shares, you could buy a Put Option with a $ 20 strike price (price at which you could sell shares for if you owned them) and the option might cost you around $ 1
If your view on the stock was correct and it fell below $ 20 then your Put Option would be worth more than the $ 1 you paid (Puts go up in value alongside fall in share price)
You could then sell your bought Put Option to another trader at a higher price, realising a profit as you do.
Education and experience are key in selecting the right Put Option for the most profitable result. As a rule, the further away your option strike price is from the current share price (out-of-the-money), the bigger the fall you need in share price to reach a break-even or profit point.
How Does a Put Option Benefit You?
The major benefit to you as a trader is that you do not need to outlay large sums of money and you can create a profit from shares that are falling in value.
There are countless investment and trading vehicles that allow you to profit from falling share prices, however, many of them present unlimited potential losses.
Buying Put Options (Long Put) offers you a leveraged alternative to strategies such as “short selling’ with a much lower potential risk.
The same as buying Call Options, you have a limited pre-determined financial risk with a long Put and the maximum amount of funds you ever have to commit to the trade is what it cost to buy the option (+ brokerage of course)
When you employ other trading vehicles, such a short selling the stock, not only are your potential losses unlimited, but you are required to hand over more money for margin to actually establish the position.
Regardless of stock market conditions, when you hold a Long Put you will never require a margin call, and as the stock price falls and your Put Option contract becomes more profitable, the increasing leverage will deliver large percentage profits.
What is Your Risk vs Reward?
PROFIT: Your maximum profit potential is only limited to the stock price falling to z
ero as a Put Option value will increase as the share price falls.
LOSS: Your maximum loss is limited to what you pay to own the Put Option initially.
If you never used your Put Option (exercised your right) or sold it to someone else and it expired worthless, then you would lose the whole amount that you paid to own the Put Option contract.
Your break-even point would occur when the share price fell by the amount which you paid for the Put Option.
Do You Have to Buy or Sell the Shares?
NO! When you own a Put Option, you are under no obligation to sell any shares, or ‘exercise’ your right. You control when and if you buy or sell and you can do so at any time up until the expiry date of the Put Option.
In the event of the share price falling below the Put Option strike price, you could do one of two things:
1) You could exercise your Put Option of course you would need to buy the shares first at the lower current trading price before you could sell them using your Put Option. In this situation, the difference between the option strike price and current trading price is your profit however you would need to outlay the capital needed to purchase the shares to do this.
2) You could sell your Put Option to another trader for a profit. This is an Option Trading Strategy called Short Term Trading and is one of the most common ways investors use stock options.
Remembering that, as the share price falls, the value of your Put Option goes up too.
You could sell your Puts to the market at a higher value than what you paid to own them, and you would only be outlaying a fraction of the money you’d need to short sell the stock.
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