Put Options (Buying): The Complete Trading strategies
What Is a Put Option?
A put option is a derivative investment that gives the option buyer the right to sell a fixed quantity of shares of an underlying security at a set price before the put option contract expires. If the buyer chooses to sell the shares, they do so at the predetermined price in the contract. Investors can buy or sell put options on numerous types of securities, such as stocks, bonds, ETFs, indexes, commodities, currencies, or a combination of several financial instruments. To invest in an option contract, the holder must have a brokerage account with a brokerage firm
How put options work?
Put options can be used for hedging or speculation. But when it comes to the basics, they work like this: The value of a put increases as the underlying stock value decreases, and conversely, the value of a put decreases when the underlying value of the stock increases.
When you buy a put option, you're placing a bet that the value of the underlying stock will decrease in value over the course of the contract.
When you sell a put option, you're placing a bet that the value of the underlying stock will increase or stay the same value over the course of the contract.
For a put buyer, if the market price of the underlying stock moves in your favor, you can elect to "exercise" the put option or sell the underlying stock at the strike price. American-style options allow the put holder to exercise the option at any point up to the expiration date. European-style options can be exercised only on the date of expiration.
For a put seller, if the market price of the underlying stocks stays the same or increases, you make a profit off of the premium you charged the seller. If the market price decreases, you have the obligation to buy back the option from the seller at the strike price.
Buying a put option
Put options can function like a kind of insurance for the buyer. A stockholder can purchase a "protective" put on an underlying stock to help hedge or offset the risk of loss from the stock price falling.
But, importantly, investors don't have to own the underlying stock to buy a put. Some investors buy puts to place a bet that a certain stock's price will decline because put options provide higher potential profit than shorting the stock outright.
If the stock declines below the strike price, the put option is considered to be “in the money.” An in-the-money put option has "intrinsic value" because the market price of the stock is lower than the strike price.
The buyer then has two choices......
First, if the buyer owns the stock, the put option contract can be exercised, putting the stock to the put seller at the strike price. This illustrates the "protective" put because even if the stock's market price falls, the put buyer can still sell the shares at the higher strike price instead of the lower market price.
Second, the buyer can sell the put before expiration in order to capture the value, without having to sell any underlying stock.
If the stock stays at the strike price or above it, the put is “out of the money” and the option expires worthless. Then the put seller keeps the premium paid for the put while the put buyer loses the entire investment.
4 Types of Put Option Strategies
There are several common trading strategies when it comes to put options:
1. Long put: This is the most common put option strategy and involves the investor taking on the role of the option contract holder (aka the buyer). In a long put, the investor bets that the underlying stock or asset price will decrease.
2. Short put: In a short put also called a naked put the investor takes on the role of the option contract writer (aka the seller). In a short put, the investor bets that the underlying stock or asset price will increase. Investors who use this strategy aim to profit off the option premium fee that the buyer pays them at the contract’s start. Short puts can be risky since the investor is potentially obligated to buy worthless shares in the underlying asset if the market price of the shares plummets drastically.
3. Protective put: Protective put options are essentially an insurance strategy investors can use when taking a long position on a regular stock market trade. For example, if an investor purchases stock shares, they're hoping the stock price increases, but they could also buy a protective put so that if the stock price decreases below the put option's strike price, they still profit on the put option. If the stock price increases above the strike price, they profit off the stock trade and only lose the cost of their option premium on the protective put.
4. Bear put spread: Also known as a debit put spread, this is a strategy for options investors who want to decrease the cost of holding an options contract using a short put option to fund a long put option. In a bear put spread, the investor simultaneously buys and sells a put option contract with the same expiration date on the same underlying asset but with different strike prices. This strategy reduces the trade risk and limits profits to the difference between strike prices.
Some Other Options Strategies
The four strategies outlined here are straightforward and can be employed by most novice traders or investors. There are, however, more complex and nuanced strategies than simply buying calls or puts. While we discuss these types of strategies elsewhere, here is just a brief list of some other basic options positions that would be suitable for those comfortable with the ones discussed above:
Married put strategy: Similar to a protective put, the married put involves buying an at-the-money (ATM) put option in an amount to cover an existing long position in the stock. In this way, it mimics a call option (sometimes called a synthetic call).
Protective collar strategy: With a collar, an investor who holds a long position in the underlying buys an out-of-the-money (i.e., downside) put option, while at the same time writing an out-of-the-money (upside) call option for the same stock.
Long straddle strategy: Buying a straddle lets you capitalize on future volatility but without having to take a bet whether the move will be to the upside or downside either direction will profit. Here, an investor buys both a call option and a put option at the same strike price and expiration on the same underlying. Because it involves purchasing two at-the-money options, it is more expensive than some other strategies.
Long strangle strategy: Similar to the straddle, the buyer of a strangle goes long on an out-of-the-money call option and a put option at the same time. They will have the same expiration date, but they have different strike prices: The put strike price should be below the call strike price. This involves a lower outlay of premium than a straddle but also requires the stock to move either higher to the upside or lower to the downside in order to be profitable.
What Are the Advantages Of Put Options?
Since buying an options contract involves deciding between buying a put or a call option, it is important to understand the advantages. However, when compared with each other, a put option offers better advantages than a call option. Read on to learn the advantages offered by a put option that is unavailable with a call option.
1. Favourable Time Decay
Time is of the essence when you enter into derivative trading intending to make profits, and options are a time-bound asset that provides the put sellers with a favourable advantage. The nearer an options contract is to the completion of its specified period, the less valuable it becomes. Thus, the put option sellers are likely to benefit through the time decay by selling the contract while the option still offers value to them. In this case, however, the person with the call option is not favoured by the time decay.
2. Favourable Price Direction
The stock or the underlying asset of an option can move in any direction. It can rise or fall significantly based on social, economic and political developments. As an investor with a call option, it becomes necessary to buy the option at a price lower than the strike price for it to be profitable. However, investors with a put option can profit if the underlying asset’s price remains unchanged or even if it drops slightly. This ensures that a trader with a put option is more likely to profit than a call option’s trader.
3. Favourable Implied Volatility
Implied volatility refers to an option contract’s expensiveness. When the implied volatility in a market is high, the option contract’s price tends to be more expensive. As a trader with a put option, you would want to sell when the price is high and buy the assets when the price drops. This is possible only when the implied volatility is high but decreases subsequently with time. Market observers over the years have noted that high implied volatility has a natural tendency to drop over time, which means that traders with a put option are bound to make profits over some time since the natural conditions of the market are in
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