Profit From Falling Stocks Without Taking On Unlimited Risk
A put is a type of options contract. It gives the owner the right, but not the obligation, to sell 100 shares of the underlying stock at a specified price (known as the “strike price”) at any time before the expiration date.
Changes in the price of the underlying stock will lead to a change in the value of the put. So will changes in the volatility of the underlying stock. If the stock experiences volatility, the put should go up in price. This is because there is a greater chance (all else being equal) it will reach the strike price by the expiration date. Falling volatility lowers this chance, so it should decrease the value of the put.
In addition, the put will also change in value based on how much time is left until the expiration date. All else equal, the put will be less valuable as it gets closer to the expiration date.
Today, let’s focus on buying put options. We’ll cover the reasons to buy put options, how they work, and the various reasons a trader might use them…
How Traders Use Put Options
Buying put options gives the trader a chance to enjoy the benefits of leverage, paying relatively large rewards for a defined amount of risk. Traders who buy puts are typically bearish on a stock. There are also option contracts available on some ETFs, indexes, and futures.
For example, consider Apple (Nasdaq: AAPL). If AAPL is trading near $362 a share, 100 shares would cost $36,200.
A trader who thinks AAPL will fall could short the stock, but that would require a large amount of margin. And the risk a trader faces in a short position is unlimited. Instead of selling AAPL short, a trader could buy a put contract.
If a trader thinks AAPL should fall within the next few weeks, they could buy a put option that allows them to sell 100 shares of AAPL for $340 (the strike price) at anytime in the next two months (the expiration is 60 days away) for a price of about $12 per share (the option premium). This would allow them to participate in any price decline while limiting their risk to only $1,200.
If AAPL fell to $340 a share at the expiration date, the trader would make $800 on one contract. This assumes that the trader could sell short the 100 shares for $362 and immediately buy them back in the market for $340. The premium of $1,200 is deducted from the profits ($2,200 – $1,200 = $800). The trader would close their position and make a return of 66% on their investment ($800/$1,200 = 66%).
If AAPL closed above $340 on the expiration date, the trader loses their entire investment. This is because the cost to close the put contract would not cover the cost of the premium. However the loss is no more than $12 per share no matter how high AAPL goes.
The actual price move in AAPL would determine the price of the option. Puts can be bought or sold at any time and the trader would be able to take a profit or cut their loss at any time during the trade.
Why Put Options Matter To Traders
Traders can use puts to make bearish bets on individual stocks. Because puts have various expiration dates, a trader can make a short-term bet or a longer-term trade. They also help traders hedge their portfolios and profit in bear markets. Put options are also appealing because of their limited loss potential. They are often preferable to selling individual stocks short, since shorts carry (theoretically) unlimited risks for traders.
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