Let’s say that a stock you have been watching has been trending ever lower in price over the last six months. If the stock in question is currently trading at $40 and you believe it will fall lower, buying a put at the $42 strike price might be a good strategy.
As the price of the stock falls below $40 your put at the $42 strike price becomes even more valuable.
A put option at the $42 strike increases in price because the put option gives the owner the right to sell shares of stock at $42 even though the price of the stock is lower.
Now let’s not forget, with all this talk of profits, that if the stock is at or above $42 at expiration you would lose your entire capital invested in this position. 3 Quick & Easy Ways to Tell if a Stock is a Buy or Sell plus investing tips and info directly to your inbox. If you hold a put option you want the price of the underlying stock to decrease, whereas when purchasing a call option, you want the security’s value to rise. You would like to profit from this price action but you don’t want to bother shorting the stock. If the stock were to fall to $35 a share your $42 put option would have $7 of intrinsic value, not including any time value that remains depending on how far away expiration Friday is.
A position that can allow you to profit with less risk would be to purchase a put option contract.
Intrinsic value is calculated by taking the strike price of the option and subtracting the current price of the stock ($42 – $40 = $2). If you were to short the stock to take advantage of falling prices, your risk would technically be unlimited, as the stock could theoretically climb to indefinitely. In the money options have a statistically higher chance of expiring in the money and thus making you a profit.
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