A Quick Lesson on Buying Put Options
Options trading can be a powerful tool for either the speculator/trader or the risk avoider. In this entry I'm going to provide you with a situation where you might want to buy (and later sell) put options. As always, perform your own comprehensive research before making ANY investment decisions; do not make decisions based solely on content you gather at this site.
Quick Intro
Options can come in different flavors, notably puts or calls. Options contracts represent the right, but not the obligation, to buy or sell a security by a certain date for a certain price. For more in-depth info on options, check out the wikipedia options entry.
A put option provides the option contract holder the right, but not the obligation, to sell 100 shares of a security at a certain price. How might you use put options to bring home some extra clams?
Put Option Example #1
You want to make profit off of a stock that you believe is going to sink soon. Let's give that stock the ticker HOTSTOX. You're not comfortable selling short. If you sell short and the stock rises (maybe you're out enjoying fresh air instead of closely monitoring the streaming ticker?), the downside of your investment is limitless. AKA you could owe a hell of a lot of money to your brokerage. Alternatively if you buy a put option, the most you can lose is what you put in.
Wait a minute... how could owning (and then selling) put options make you money if the stock sinks? Good question. I mean, why would a put have any value at all?
Suppose you owned a stock that was trading for $30/share. If someone offered to buy that stock from you for $50, that's a pretty good deal for you. You'd be pocketing a premium bonus of $20/share (on top of the $30 it's worth) all in one profitable swoop. Not too shabby.
So the ability to sell your shares for a certain price might be worth something to you. At a very basic level, that's one way I like to think of puts. The ability to sell stock at a certain price -- if I want to -- is worth something to me. If I were to pay $20 to sell my shares tomorrow at $50, I'd break even, so that doesn't sound too attractive. But there is some price where it might be worth it to me. That's one thing to consider when figuring out how much put options are worth to you. Some refer to that difference as the intrinsic value of an option.
So now you see that put options are worth something to someone, here's an example of putting ... puts to use for you:
Suppose HOTSTOX is trading for $54/share, and here we are in early November. You strongly believe HOTSTOX will drop by at least a few points by December. You browse over to the HOTSTOX options listing on Yahoo! Finance to discover that DEC 55 puts (i.e., put options that expire in December and give you the right to sell 100 HOTSTOX shares for $55/share) are trading for $3.20. Note that this $3.20 amount describes cost per share. Since each options contract applies to 100 shares...
# of shares per contract: 100
option price per share: $3.20
total option contract price to you: 100 shares x $3.20 / share = $320 [+ commission]
You bite your upper lip and place a limit order to buy 1 put option contract for $3.20. You sleep well that night.
The next day an OPEC bigwig stubs his toe while getting on a boat in the Persian Gulf, and HOTSTOX drops from $54 all the way down to $51. You still hold the right to sell shares of HOTSTOX at $55, so the difference there just got bigger. You check the options pricing for HOTSTOX and notice that the same put options you bought yesterday for $3.20 are trading for $5.00* now. You jump up and down for joy and place a limit sell order for your put option $5.00. Your profit on the transaction?
purchase price: $320 per contract (remember, 100 shares per contract)So that's one example of how you might buy and sell a put in order to collect some serious cabbage (+56% in that example). Keep in mind that gains might not happen that quickly; gains might not be that sharply; and gains might not happen at all.
sales price: $500 per contract
net change: $500 - $320 = $180! (minus some $ for commissions)
Also, remember that in this case you have to sell at some point in order to make money. Picking a selling point might be tough, but you've got to come up with something that works for you. I'd advise against buying/selling any securities/options/etc. until you've come up with a selling plan that you can stick to.
Good luck!
Full disclosure: HOTSTOX is not a real stock ticker, so I definitely don't own any position in HOTSTOX. Proceed with caution when trading any securities, especially options.
* Note that an options contract price takes into account other things in addition to intrinsic value. Visit the wikipedia options page mentioned above for more information on options.
You don't have to sell your option to make money, though. As long as the stock is down when the option expires, you can pick up the shares for market value & sell them at the option price. Isn't that how it works? Obviously, you can go for the quick buck if someone buys your option, but if they don't (or you think it will STILL go down), you can still let it play out.
Dave: good point; that's definitely a legitimate approach to profiting off of puts.
The best luck I've personally had with options involves selling before expiration (instead of exercising). In fact, I've never exercised any of the options I've owned / traded. I think the reason I dump them before expiration is that I'm afraid that if I'm "in the money" now, soon the stock price will change in a way I don't like. Profit is profit, but losing money sucks!
For me, trades like that can be tough on the stomach. Should I hold longer? Oh crap I'm down 40%... Should I sell now? Should I wait until closer to expiration and exercise for profit? I've found the easiest way for me to deal with the stress surrounding those circumstances and decisions is to buy & sell options in increments (just like I do with individual stocks).
Nothing wrong with doing that, I just wanted to point out the...let's say "normal" way of using an option. I mean, if you couldn't make money off holding it, it wouldn't be worth much to hold onto it. ;-)
And really, what I find the best measure of "should I wait" is whether or not my net profit is "high enough" once I've annualized it. Making 1% on something isn't bad if you did it in one week.
I once heard a phrase that I really liked. "No one ever got rich by selling too late." Admittedly, you can sell "too early" and not make as much, but if you've made "enough for now," sell, revel in your profit, and don't look back. If you're not going to be in it for the long haul, take the money and run. Obviously, if you're planning on letting something be a long-term investment (eg. planning on letting the dividends be a source of income or you think they'll just steadily climb), that's different. But if you're buying a put option, you're OBVIOUSLY not exactly confident in the stock, so it's intended as a short term money-maker. :-)