When the market is volatile, as it has been recently, investors may need to re-evaluate their strategies when picking investments. While buying or holding long stock positions in the market can potentially lead to long-term profits, options are a great way to control a large chunk of shares without having to put up the capital necessary to own shares of bigger stocks - and, can actually help hedge or protect your stock investments.
In fact, having the option to sell shares at a set price, even if the market price drastically decreases, can be a huge relief to investors - not to mention a profit-generating opportunity.
So, what is a put option, and how can you trade one in 2019?
What Is a Put Option?
A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an underlying security at a set price at a certain time. Unlike a call option, a put option is typically a bearish bet on the market, meaning that it profits when the price of an underlying security goes down.
Options trading isn't limited to just stocks, however. You can buy or sell put options on a variety of securities including ETFs, indexes and even commodities.
Still, options trading is often used in place of owning stocks themselves. For example, if you were bearish on a particular stock and thought its share price would decrease in a certain amount of time, you might buy a put option which would allow you to sell shares (generally 100 per contract) at a certain price by a certain time. The price at which you agree to sell the shares is called the strike price, while the amount you pay for the actual option contract is called the premium. The premium essentially operates like insurance and will be higher or lower depending on the intrinsic or extrinsic value of the contract.
Essentially, when you're buying a put option, you are "putting" the obligation to buy the shares of a security you're selling with your put on the other party at the strike price - not the market price of the security. When trading put options, the investor is essentially betting that, at the time of the expiration of their contract, the price of the underlying asset (be it a stock, commodity or even ETF) will go down, thereby giving the investor the opportunity to sell shares of that security at a higher price than the market value - earning them a profit.
For example, if you wanted to buy a put option on Intel (INTC - Get Report) stock at a strike price of $48 per share, expecting the stock to go down in price in six months to sit at around $45 or $46, you could make a decent profit by exercising your put option and selling those shares at a higher price if the market price of the stock goes down like you thought it would.
Options are generally a good investment in a volatile market - and the market seems bearish and that's no mistake. Despite a rally early in January that saw the Dow Jones Industrial Average rise some 98 points (with the S&P 500 and Nasdaq following suit with 0.7% and 1.26% increases respectively), the overall market has been nothing but volatile in recent months.
Yet, volatility (especially bearish volatility) is good for options traders - especially those looking to buy or sell puts.
Still, what is the difference between a put option and a call option?
Put vs. Call Option
While a put option is a contract that gives investors the right to sell shares at a later time at a specified price (the strike price), a call option is a contract that gives the investor the right to buy shares later on. Unlike put options, call options are generally a bullish bet on the particular stock, and tend to make a profit when the underlying security of the option goes up in price.
Put or call options are often traded when the investor expects the stock to move in some way in a set period of time, often before or after an earnings report, acquisition, merger or other business events. When purchasing a call option, the investor believes the price of the underlying security will go up before the expiration date, and can generate profits by buying the stock at a lower price than its market value.
So, how do you buy a put option?
How to Buy a Put Option
Just like with call options, put options can be bought through brokerages like Fidelity or TD Ameritrade (AMTD - Get Report) . Because options are financial instruments similar to stocks or bonds, they are tradable in a similar fashion. However, the process of buying put options is slightly different given that they are essentially a contract on underlying securities (instead of buying the securities outright).
In order to trade options in general, you will need to be approved by a brokerage for a certain level of options trading, based on a form and variety of criteria which typically classifies the investor into one of four or five levels. You can also trade options over-the-counter (OTC), which eliminates brokerages and is party-to-party.
Options contracts are typically comprised of 100 shares and can be set with a weekly, monthly or quarterly expiration date (although the time frame of the option can vary). When buying an option, the two main prices the investor looks at are the strike price and the premium for the option. For example, you could buy a put option for Facebook (FB - Get Report) at a $7 premium with a strike price of $143 (meaning you are agreeing to sell the shares at $143 once the contract expires if you so choose).
Still, what affects the price of the put option?
Time Value, Volatility and "In the Money"
Apart from the market price of the underlying security itself, there are several other factors that affect the total capital investment for a put option - including time value, volatility and whether or not the contract is "in the money."
The time value of a put option is essentially the probability of the underlying security's price falling below the strike price before the expiration date of the contract. For this reason, all put options (and call options for that matter) are experiencing time decay - meaning that the value of the contract decreases as it nears the expiration date. Options therefore become less valuable the closer they get to the expiration date.
But apart from time value, an underlying security's volatility also affects the price of a put option. In the regular stock market with a long stock position, volatility isn't always a good thing. However, for options, the higher the volatility (or the more dramatic the price swings) of a given stock, the more expensive the put option is. This is primarily due to how the put option is betting on the price of the underlying stock swinging in a set period of time. So, the higher the volatility of an underlying security, the higher the price of a put option on that security.
One of the major things to look at when buying a put option is whether or not the option is "in the money" - or, how much intrinsic value it has. A put option that is "in the money" is one where the price of the underlying security is below the strike price of the option. The option is considered "in the money" because it is immediately in profit - you could exercise the option immediately and make a profit because you would be able to sell the shares of the put option and make money. To this degree, an "at the money" put option is one where the price of the underlying security is equal to the strike price, and (as you may have guessed), an "out of the money" put option is one where the price of the security is currently above the strike price.
Because "in the money" put options are instantly more valuable, they will be more expensive. When buying put options, it is often advisable to buy "out of the money" options if you are very bearish on the stock as they will be less expensive.
Put Option Strategies
How can you trade put options in different markets?
While the general motivation behind trading a put option is to capitalize on being bearish on a particular stock, there are plenty of different strategies that can minimize risk or maximize bearishness.
1. Long Put
A long put is one of the most basic put option strategies.
When buying a long put option, the investor is bearish on the stock or underlying security and thinks the price of the shares will go down within a certain period of time. For example, if you are bearish on Apple (AAPL - Get Report) stock (which many investors are after they cut their first-quarter revenue forecast), you could buy a put option on Apple stock with a strike price of $150 per share, thinking its market value will decrease to around $145 in six months. Since the current price of Apple stock sits at around $153 per share, your put option would be "out of the money" and therefore less expensive. The more bearish you are on the stock, the more "out of the money" you'll want to buy the stock. However, if the stock price does drop before the expiration date of your contract, you would be able to make a nice profit by exercising your put option and selling shares of Apple stock at $150 instead of the lower market price they are now worth.
Long options are generally good strategies for not having to put up the capital necessary to invest long in an expensive stock like Apple, and can often pay off in a somewhat volatile market. And, since the put option is a contract that merely gives you the option to sell the shares (instead of requiring you to), your losses will be limited to the premium you paid for the contract if you choose not to sell the shares (so, your losses are capped). As a disclaimer, like many options contracts, time decay is a negative factor in a long put given how the likelihood of the stock decreasing enough to where your put would be "in the money" decreases daily.
2. Short Put
The short put, or "naked put," is a strategy that expects the price of the underlying stock to actually increase or remain at the strike price - so it is more bullish than a long put.
Much like a short call, the main objective of the short put is to earn the money of the premium on that stock. The short put works by selling a put option - especially one that is further "out of the money" if you are conservative on the stock.
The risk of this strategy is that your losses can be potentially extensive. Since you are selling the put option, if the stock plummets to near zero, you are obligated to buy a virtually worthless stock. Whenever you are selling options, you are the one obligated to buy or sell the option (meaning that, instead of having the option to buy or sell, you are obligated.) For this reason, selling put (or call) options on individual stocks is generally riskier than indexes, ETFs or commodities.
With a short put, you as the seller want the market price of the stock to be anywhere above the strike price (making it worthless to the buyer) - in which case you will pocket the premium. However, unlike buying options, increased volatility is generally bad for this strategy. Still, while time decay is generally negative for options strategies, it actually works to this strategy's favor given that your goal is to have the contract expire worthless.
3. Bear Put Spread
While long puts are generally more bearish on a stock's price, a bear put spread is often used when the investor is only moderately bearish on a stock.
To create a bear put spread, the investor will short (or sell) an "out of the money" put while simultaneously buying an "in the money" put option at a higher price - both with the same expiration date and number of shares. Unlike the short put, the loss for this strategy is limited to whatever you paid for the spread, because the worst that can happen is that the stock closes above the strike price of the long put, making both contracts worthless. Still, the max profits you can make are also limited.
One bonus of a bear put spread is that volatility is essentially a nonissue given that the investor is both long and short on the option (so long as your options aren't dramatically "out of the money"). And, time decay, much like volatility, won't be as much of an issue given the balanced structure of the spread.
In essence, a bear put spread uses a short put option to fund the long put position and minimize risk.
4. Protective Put
Also dubbed the "married put," a protective put strategy is similar to the covered call in that it allows an investor to essentially protect a long position on a regular stock.
As far as analogies go, the protective put is probably the best example of how options can act as a kind of insurance for a regular stock position. To use a protective put strategy, buy a put option for every 100 shares of your regularly-owned stock at a certain strike price.
If the stock price plummets below the put option strike price, you will lose money on your stock, but will actually be "in the money" for your put option, minimizing your losses by the amount that your option is "in the money."
Put Option Examples
Here are some actual examples of put option strategies:
Say you want to buy a long put for Oracle (ORCL - Get Report) stock that is currently trading at $45. If you're moderately bearish on the stock, you could buy a put "at the money" with a strike price of $45 per share for a $3 premium on 100 shares, set to expire in three months - making the cost of the contract $300 ($3 times 100 shares). Given the long put strategy, $300 is the max amount you can lose on the trade. If the stock falls to $35 per share by the time of the expiration date, you will be $10 "in the money" on your long put, making you a $700 profit on the option (or, the new value of the contract at $1,000 minus the premium of $300).
Another example is a short put option on Twitter (TWTR - Get Report) stock trading at $30 per share. Say you wanted to sell a put (a short put) on the shares at a $25 strike price with a $2 premium on 100 shares (so, a $200 premium). Since you are selling the option, you instantly get the $200 credit (or profit) - being the maximum profits you can make on the trade. However, your loss is hypothetically unlimited if the stock sinks deeper. Remember, the goal of a short put is to have the contract expire worthless so as to pocket the premium (in this case, the $200).
With any options trading, it is important to evaluate the market and your attitude on the individual stock, ETF, index or commodity and pick a strategy that best fits your goals.