October 6, 2017

Put Options: What You Need to Know

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Betting against a stock is a thing. It's called a put option. It's for those investors who think a particular stock price will decline.

You can even cover the stocks you sold short with a put option.

Did we just make your head spin? Don't worry - by the time you're done reading this article, you'll understand what you need to know about put options. In general, this strategy is recommended for people who have experience in stock trading.

So, you might need to get your feet wet first. But explore the information below - you might find yourself able to invest in more stocks than you thought possible.

What Is a Put Option?

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While not as common as call options (when the owner is reserving the right to buy shares of stock), put options can be just as profitable. A put option allows the owner to sell a stock at a specific price. The price is what's known as the predetermined strike price. But there's a time limit: The transaction must occur within a certain time frame or the right to sell expires.

Each of these contracts is worth 100 shares. When you buy one put contract, you are buying the right to sell 100 shares at the strike price.

Here's how to think of it in the simplest of terms: As the buyer of a put option, you want the stock price to fall below the strike price. It's like a bet. You're paying to wager that the stock price will decrease.

If it does decrease, you'll want to execute your right to sell the stock. You get the stock at the strike price. And your profit is the difference between the strike price and the current market value minus the premium paid.

How Do You Buy a Put Option?

Investors buy a put option when they think the market will go down. The idea is to have the contract with a higher strike price. When the market does tank, they have the right to sell their stock at a higher price - and walk away with a profit.

You buy a put contract for a premium. Let's say you can buy a put option for ABC Company for a $2 premium. You'll pay $200 for the contract. Let's say the strike price is $50. The current market price of the stock is $50. You have a hunch that the stock will lose value within the next 3 months. You buy a put with an expiration 3 months out.

Let's say the stock falls to $45 within 3 months. You can execute your contract. This means you can sell 100 shares of the ABC Company stock for $50 per share. You don't have to own the shares either. You can buy them on the market for $45 or $4,500. You can then turn around and sell them for $50 or $5,000.

Your profit is $500, but don't forget about the premium. You paid $200. So you walk away with a net profit of $300.

If the stock's price didn't fall, you wouldn't execute the contract. Instead, you'd let it expire. The most you would be out is the $200 premium.

What Are the Benefits of Buying a Put?

Buying a put is a fairly safe investment strategy. It allows you to take advantage of a declining market with little capital. At the most, you stand to lose your premium. You know your maximum loss going into the investment. If stock prices don't fall, you don't have to do anything.

Your maximum upfront investment is the premium. You don't have to buy the stock unless you execute the put. This minimizes your investment. If, on the other hand, you shorted the stock, you'd have to buy it at some point. You borrow the shares in the hope that you'll be able to buy them on the market at a lower price.

Knowing what you stand to lose makes buying a put a much safer investment, especially for beginners.

How Can You Sell Puts?

It's also possible to sell puts. As the seller, you are known as the writer. The seller is on the opposite end of the spectrum. He wants the stock price to increase rather than decrease. He takes the gamble that the stock's price won't fall. This way the contract will expire unused. This leaves the writer with the premium in his pocket.

There are two types of puts you can sell - covered puts and naked puts.

A covered put occurs when the writer sells stocks short. He then writes a put to protect his investment and minimize his losses. Here's an example.

ABC stock is trading for $50 today. John sells ABC stock short and then writes a covered put. He sells the put for a $2 premium and with a 3-month expiration. The strike price is $45. John collects $200 up front for the contract.

Then, 3 months later, before the contract will expire, the stock closes at $40. The buyer executes the contract. This means John must sell the stock at the strike price of $45.

John already made $5,000 when he sold the stock short at the start of the contract. He must now buy the stock from the executed put for $45 per share. This costs John $4,500. John walks away with a total of $700. He made $500 on the transaction, plus the $200 initial premium.

Now, if the stock increased to $55, the covered put would expire worthless. It's called "out of the money." John would walk away with a significant loss. He would have made $4,500 from the short sale. But then he'd be on the hook for $5,500 to cover the short sale. His net loss would equal $800 after taking the premium into consideration.

Shorting a stock: When you short a stock, you're selling a stock you don't have. Investors do this when they think stock prices may fall. They sell stocks they don't own in the hopes that they'll buy them at a lower price. They can then walk away with a quick profit.

As for uncovered, or naked, puts, the writer doesn't short the stock. Instead, he is on the hook for the stock only if the buyer executes the put. In other words, the option must be in the money.

If the buyer executes the put, the writer must then buy the stock at the current market price. Here's an example:

ABC stock currently trades for $50. John writes a naked put with a strike price of $50 with an expiration of 3 months. He makes a $2 premium.

If in 3 months, the market price of the stock falls to $45, the buyer will execute the contract. This means John must buy the stock for $50 per share and can only sell it for $45 per share on the current market. John walks away with a loss of $300. Here's how:

$5,000 paid for the stock - $4,500 made on the market + $200 premium = $300 profit.

What Are the Benefits of Selling Puts?

Selling puts requires plenty of knowledge about stocks and options. It's not for the novice investor. If you do get into it, though, you may experience the following benefits:

  • If the stock price doesn't fall, you walk away with a profit from the premium collected.
  • Even if you do suffer a loss, you can offset it with the premium collected for the contract.
  • You don't have to have a lot of capital even if the put is executed as long as it's a naked put.

It takes some work to educate yourself on the best moves to make, but selling puts can help diversify and strengthen your portfolio.

The Final Word

Buying and selling puts can help you make money without a large amount of capital. It can also help hedge against losses when you short a stock.

As you figure out the best strategy, make sure to take commissions into consideration. Shop around to find the brokerage with affordable commissions but plenty of support. This way you can maximize your efforts buying and selling puts.

And do be sure to read up on investment strategies and market and industry news. Always do your homework on the companies you're investing in as well as the overall market.

More from CreditDonkey:

Call Options

How to Trade Options

Options Trading Mistakes

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