Practical finance

Options strategies 4 – PUT options

Put options provide traders and investors with a flexible risk management tool. While call options are used to benefit from price increases, put options allow traders to profit from price declines or hedge existing stock positions. Understanding how to strategically buy and sell puts is crucial for both defensive and opportunistic trading.

Buying Puts: Protecting Against Losses

The outright buyer of a put benefits when the stock price declines. A put is:

  • In-the-money (ITM): when the stock price is below the put’s strike price.
  • Out-of-the-money (OTM): when the stock price is above the put’s strike price.

Using Puts with Stock Ownership

Put options can limit downside risk while still allowing upside potential in stock holdings.

When to Use Put Protection:

  1. For Long-Term Holders: If an investor owns a stock but does not want to sell it, buying a put can protect against short-term declines while maintaining long-term exposure.
  2. For New Buyers Seeking Insurance: If an investor buys a stock but wants insurance in case the trade goes against them, buying a put ensures they can sell at a fixed price, limiting losses.

This approach is similar to portfolio insurance, where traders hedge their positions during uncertain market conditions.

Straddle: Combining Puts and Calls for Volatility Plays

A straddle involves buying a put and a call with the same strike price and expiration date. This strategy profits if the stock makes a large move in either direction—the investor doesn’t need to predict whether the stock will rise or fall, just that it will move significantly.

Example: XYZ at $50

  • Buy XYZ July 50 Call for $3
  • Buy XYZ July 50 Put for $2
  • Total Cost: 5 Points (Total Debit = $500 per contract)

How the Straddle Works:

  • If XYZ rises above $55, the call will be worth more than 5 points, resulting in a profit.
  • If XYZ falls below $45, the put will be worth more than 5 points, also resulting in a profit.
  • If XYZ stays near $50, both options may expire worthless, resulting in a loss of the initial investment.

When to Use a Straddle:

  • When expecting high volatility (e.g., before earnings, economic events, or major news).
  • On stocks with historically large price swings.

Straddles are not ideal for low-volatility stocks, as both the put and call premiums will decay over time if the stock doesn’t move significantly.

Selling Puts: Profiting from Stability and Accumulating Stock

How Selling Puts Generates Profit

A trader profits from selling a put when the stock remains above the strike price at expiration. The seller receives the premium as income, but is obligated to buy the stock if it drops below the strike price.

  • Maximum Profit: The premium received.
  • Maximum Loss: Significant if the stock declines sharply.

Selling Puts to Buy Stock at a Discount

Selling puts can be an alternative to placing a limit buy order.

Example: Selling Puts Instead of a Limit Buy Order

  • XYZ is trading at $60, and the investor wants to buy at $55.
  • Instead of placing a limit order at $55, the investor sells a long-term put at the $60 strike for $5 premium.
Possible Outcomes:
  1. If XYZ falls below $60:
    • The investor is assigned the stock at $60.
    • Since they received $5 from selling the put, their effective purchase price is $55.
  2. If XYZ stays above $60:
    • The investor does not buy the stock.
    • They still keep the $5 premium as profit.

This strategy is useful for investors looking to accumulate stock at a lower price while earning premium income.

Risks of Selling Puts

  • Large Losses Possible: If the stock crashes, the put seller must buy at the strike price, even if the stock is trading much lower.
  • Ties Up Capital: The put seller must keep enough cash or margin available to buy the stock if assigned.

Key Takeaways

  1. Buying puts is a defensive strategy to hedge stock ownership or bet on price declines.
  2. Straddles provide exposure to large moves in either direction, useful for high-volatility scenarios.
  3. Selling puts generates income and allows traders to accumulate stock at a lower price, but exposes them to significant downside risk.

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