Put options are bought when you have a bearish (market heading lower) view on the market or on a particular stock.
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. 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. 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.
As a quick review, a Call option contract gives us the right to buy 100 shares of the underlying security and is a nice tool to place a speculative long trade with tightly defined risk while tying up a small amount of trading capital. 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). In the money options have a statistically higher chance of expiring in the money and thus making you a profit. A Put is similar in structure to a Call, but is the right to sell 100 shares of the underlying security at a set strike price.
Since a Put increases in value as the underlying drops in value it can be used as a vehicle to protect portfolio positions in case of a downturn as well as for a speculative short directional trade in a security.CMG Case StudyLet’s take a look at using Puts to hedge and protect gains for your account. An ideal solution is to sell ? of the shares to recover most of the original principal and use a portion of the profits to purchase a CMG Put option to lock in gains on the remainder. A protective put creates a loss protecting floor at the strike price minus the cost of the put.
Let’s examine the results comparing an in the money 400 strike put with an at the money 380 strike put. From the previous article we remember that in the money options have a higher delta which means they are more sensitive to changes in the stock price.
Because no matter how far the CMG stock trades under the strike price, you would still have a right to exercise the option and sell your shares at the strike.
If you felt that CMG had found price support here at the $300 level and was done with its correction, you could sell your put to close the initial option position and buy a lower strike put farther out in the calendar (i.e.
The net profits going forward from continued CMG appreciation would be greater since you had taken a bunch of option premium off the table and switched from a very deep in the money to an at the money put. Just be careful not to roll until you definitely have seen signs of price support and better odds of a sustained reversal higher.Profit from Stock Drop Using Speculative PutThe opportunity to buy a put option without owning CMG shares could have been used for a speculative directional trade in order to profit from an anticipated drop in CMG. If you use puts to make defined risk directional short trades, stay small, be sure to calculate your breakeven point (Strike Price – Put Premium) and be very aware of the time value or Theta decay that reduces the price of the put and erodes your potential profit.In upcoming articles, we’ll explore more option portfolio protection strategies – writing covered calls, creating option collars, and introducing option spread trades. All will be fairly straight forward given that you already understand the Call and Put basic fundamentals that we’ve presented in this article and the previous one.
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