Buying Put Options
If you're looking for a strategy to help you protect your assets or realize a profit in a bear market, you might explore buying put options. In a market downturn, for example, you may find that having a put to exercise will provide a better return than selling off the stocks you own to prevent losses. But before you jump in, get to know this required reading: Characteristics and Risks of Standardized Options.
Generally speaking, you buy puts if you think the market or underlying investment will decrease in value.
If you own a particular stock that you buy a put option for, you're hedging your existing stock position. In fact, it's known as a protective put. There is an initial cost, which is the premium you pay for the put. But what you're doing is locking in a selling price. That protects you if the market price of the stock falls below the strike price at any time before the option expires.
If that happens, you could decide to exercise the put. An investor who sold the put must buy your shares at the strike price, even if that price is substantially higher than the stock's market price. On the other hand, if the stock's price goes up, not down, you don't exercise before expiration. That means you keep your shares. The most you can lose is what you paid to buy the put, plus any commission.
If you suspect you won't exercise, you may be able to sell your option in the marketplace before expiration. The premium you receive will be less than the premium you paid because there's less time for the option to move in-the-money. But selling could potentially reduce your loss.
You can also use a strategy known as a married put. In that case, you make two purchases at the same time: You:
- Buy shares of a stock
- Purchase a put on the same stock
In the same way that a protective put locks in unrealized gains on stocks you've held for some time, a married put helps protect the value of a new investment.
It's Your Option: Sell It or Hold It
If you buy a put option and then sell it, you can figure out your return by subtracting the amount you received from the amount you paid. For example, say you bought one put option for $250, or $2.50 per share. Six weeks later, the price of the underlying stock has dropped. That means the put is in-the-money, and you can sell your option for $500, or $5 per share. Your return is $250, or 100% of your investment.
$500 (Sale price) - $250 (Premium) = $250, or a 100% return
But if the price of the stock has risen after a month, it moves the put out-of-the-money. You decide to sell the put, but the premium has dropped to $150. That means you'll lose $100, or 40% of your investment, but not the entire amount.
$250 (Purchase price) - $150 (Sale price) = $100 or a 40% loss
The calculation is a little more complicated if you buy a put to hedge a stock position. In that case, you have to find the difference between your total investment, which is the premium plus the amount you paid for the shares, and where you'd be, financially speaking, if you exercised your option.
Suppose you bought 100 shares of a particular stock for $20 a share, spending $2,000. Then you bought one put option with a strike price of $15 on the same stock for $100, or $1 per share. That makes your total investment $2,100.
If you exercise the option, you'll receive $1,500 and have a $600 loss on your $2,100 investment.
$2,100 (Total investment) - $1,500 (Receive at exercise) = $600 Loss
Nobody likes a $600 loss. But remember that if the stock price had fallen below $15, your potential loss could have been significantly greater without the put. By adding $100 to your investment, you were assured of a $15 selling price however low the market price of the stock dropped.
Weighing Your Choice
The appeal of buying puts is that they can help manage risk in a volatile market or one that seems to be headed into bear territory. What's more, the risk of loss you face when you buy an option is limited to the cost of the premium.