Sunday, 16 May 2021

How Do Put Options Work?

How Do Put Options Work?
04 Dec

As an investor, you have a number of strategies at your disposal that can help you make money even when the market might be dropping. Additionally, you might be interested in using hedging to limit potential losses if you think the market — or a specific stock — is going to head lower.

One way to take advantage of price declines and turn them into sizable gains is to adopt a put option strategy. Before you move forward, though, it’s important to understand how put options work — and to realize that there are a number of risks associated with trading them.

What is a put option?

“A put option is a contract that allows you to sell a specific amount of an underlying asset at a specific price within a set amount of time,” said Allison Ostrander, an options trader with almost a decade of experience and the director of risk tolerance with Simpler Trading, a financial trading education company. “You have the option to sell when an asset drops to the agreed-upon price, but you’re under no obligation to do so.”

In order to better understand put options, it’s essential to know some basic terms:

  • Strike price: the agreed-upon price you are guaranteed
  • Expiration: the date at which the option expires and you’re no longer entitled to sell the asset at the agreed-upon price
  • Premium: the price you pay upfront for the right to buy a put contract
  • Assignment: when a put option contract goes through

When you buy a put option, you pay an upfront amount of money for a guaranteed price on an asset. If the price of the asset drops to the agreed-upon amount (or moves lower), you have the right to sell your asset at the price in the contract — as long as the expiration date on the contract hasn’t passed.

“Typically, this can be a great way to hedge your account if the market or the symbol you are trading appears like it will move lower,” said Ostrander.

How to make money with put options

A put option can be one way to profit in a bearish market or to limit your losses if something you own is losing ground.

Ostrander pointed to Facebook as an example of a situation in which an options trader who didn’t own the stock could have made money in the summer of 2018. “If you had opened an ‘at-the-money put’ earlier in the summer with a next-year expiration, your trades would be profitable,” she said. (As of December 2018, Facebook has declined by more than $50 per share since the end of May 2018.)

Another way to make money is to sell the put option contracts instead of buying them, said Lyn Alden, who owns investing research and education company Lyn Alden Investment Strategy and has been trading puts for about six years.

“For option sellers, their profits come entirely from the cash premiums,” said Alden. “Most of their positions expire without being assigned, meaning they were paid a premium for an option that was never used.”

Alden also said that selling put options allows investors to enter stock positions at a lower cost if they plan to hold for a while. For example, if a stock is trading at $50 per share, an investor might sell a put to buy the stock at $45. If they sell the put at a premium of $1 per share, they are basically getting in at $44 because they already have received the premium.

However, if you plan to sell puts to lower your cost basis, you should plan to hold the asset for the long term, said Alden, although it’s not the best strategy when you’re extremely bullish.

“Using that strategy, put sellers can make good money in a flat market,” Alden continued. “It works really well for volatile markets, sideways markets, or mildly bullish or bearish markets.”

Hedging your portfolio

You also can use put options to hedge against losses in your portfolio, said Alden.

Rather than watching an asset you own fall precipitously, it’s possible to limit your losses by buying a put option contract on something you’re bearish on. Say you own 100 shares of fictional XYZ Corporation stock at $135 per share. You think it will fall further, so you buy a put contract that allows you to sell your shares at $125 anytime in the next six months. Two months later, XYZ drops to $95 per share. You decide to sell. You get your $125 price, even though the market price is much lower.

At the time you bought your contract, your XYZ shares were worth $13,500. When you sold them, you got $12,500 for them instead of being stuck with selling them at the market rate of $9,500. You limited your losses to $1,000 — plus whatever the premium was — rather than $4,000. (This simple illustration doesn’t take into account trading fees and other potential costs.)

Put options vs. short selling

Put options and short selling are both ways to hedge your portfolio or make money when a market or asset is going lower.

With short selling, you borrow and sell in the market. The earning comes in if the stock declines. You buy back the stock at the lower price, pocketing the difference. Because short selling relies on margin, the losses could be much bigger than you could see trading a put option.

Short selling is more of an indirect hedge as well. Rather than shorting the asset you own, you might short a market. For example, if you own technology stocks, you might decide to short an index exchange-traded fund that focuses on the Nasdaq.

“If you own stock of the underlying asset, then selling short would go against the stock you own,” said Ostrander. Puts, on the other hand, allow you to directly limit your losses in the underlying asset by guaranteeing you a price on something you think will decline.

Short selling also can get complicated, and it is a more advanced strategy, according to Alden.

“Compared to short selling, buying puts is simpler and more accessible,” said Alden. “The main downside is there is a specific expiration date for the contract.”

Risks of put options

Anytime you trade a put option, the main risk is that you lose the premium you paid without any benefit, according to Ostrander. “If the underlying asset bounces and turns bullish or consolidates, you may find your put losing money, especially if expiration is near,” she said. “Buy time on your trade by going with a further-out expiration.”

For those who sell options, though, Alden warned that losses can result when positions are actually assigned. If you sell a put option and the buyer decides to go ahead and exercise the option when the strike price is reached, you will have to pay up. It can work out in the long run if the price recovers, but Alden said some positions can lead to significant losses.

Remember to risk only what you can afford to lose

Ostrander started with a practice account before she began risking real money, and that’s one way you can learn the ropes before you buy your first put option. Learn the markets and assets you plan to trade put options in and practice with the mechanics before committing funds.

In the end, trading put options can be a rewarding way to make money or hedge against losses. However, as with any investment, risk only what you can afford to lose. Carefully consider your risk tolerance and decide if trading put options is right for you.

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Miranda Marquit


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