Stay put! Put options: how to use them to your advantage and how to calculate your profit

Susan
By Susan August 8, 2011 10:27

Stay put! Put options: how to use them to your advantage and how to calculate your profit

 

 

A put option is the right, but not the obligation, to sell a stock. It is, in essence, an insurance policy on a financial market security.

There are two reasons why an individual or institution might buy a put option:

 

1. To protect a stock position (a protective put)

 

Let’s say that I hold (I “long”) a stock currently priced at $100. Now, let’s say that the lowest price that I want to receive for that stock at some stage in the future (the “strike date”) is $80 (strike price). Options are traded in block of 100 shares in the US market. I could pay a premium (e.g. $1 x 100 shares per block) to lock in that price via buying a put option.

I am buying the right, but not the obligation, to sell that block of 100 stocks at $8000 ($80 x 100) at a certain date in the future. As a result, I have put a “floor” under my stock. Ideally, of course, I won’t have to use (“exercise”) that option at expiry. I would prefer if the stock rises in value and I can sell the security to the market at a higher price!

 

2. To make a return in a falling market

 

If a market participant has bought the put option, they are said to be “long” in this transaction. Using the insurance policy analogy, the more risky the scenario insured, the more valuable the insurance contract or “floor” is.

As a result, if the stock is falling, the price of the put option goes up. This is a “bearish” strategy, meaning, you would only buy a put option if you felt the market was going to fall. This is referred to as “naked” trade if you don’t own the underlying stock and the only reason that you had the option is to make money on the basis that the stock would fall and hence the value of the option would rise.

The maximum amount of loss that a put buyer can have is the premium that they pay at the beginning of the contract. In the numerical example above, all that you can lose is $10 plus your transaction cost. There is an upward limit also – the furthest the share can fall is to $0, at which you would make the maximum of $8000, as this is the difference between the strike price and the market price.

In practice, there are a number of things to take into account throughout the life of the option.

Firstly, you need to decide the “strike price” to buy. This is the price that you have the right, but not the obligation to sell at. You might buy an option that is “out-of-the-money” or the strike price is below the current market price. In the above example, you would choose a strike price anywhere below $100. If the stock goes up in value or is still at $100 by the time of the expiry of the option, you will lose your premium and hence, invoke the maximum loss.

You may also buy an option that is “at-the-money”, i.e. the strike price is the same as that of the market. Again, if the stock rises or trades flat by the time of expiry, you will lose your premium.

However, a trade might start off either “out” or “at” the money and the stock price could fall below the strike price. In the above example, the price of the share falls below $80. Now this contract is “in-the-money” and  you can “exercise” your option. This means that you could sell the stock at the strike price, which is higher than the market price.

Have you actually made a profit? Indeed, you might have made money in the difference between the strike and market prices, but you also need to take away the premium that you paid as well as the transaction cost of doing so. Let’s say the market fell to $75 per share. You sold your holding at $80, since you had the put option to exercise.

You made a gross profit of $5, but you need to subtract the $1 premium to find the net effect. In fact, you made $4 less the transaction cost from buying this put option.

 

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Susan
By Susan August 8, 2011 10:27