Strategies for Retail Investors When Using Put Options
A put option gives an investor the right to sell the underlying asset at some point in the future for a pre-specified price. Individual investors can use these options to lock in a price at which they can sell a stock they currently own, increase the return on their portfolio, and /or attempt to acquire a stock for a below-market price.
Buying Put Options
Assume you purchased Stock A some time ago for $33 a share and that its price has since increased to $47. You think it’s likely that the price may go even higher, but you don’t want to lose the gain that you have if you’re wrong. You can lock in that gain by purchasing a put option with a strike price of, say, $50 a share. This strike price is higher than the current market price of the stock, and the option premium will reflect this, but if the stock price falls, your ability to sell your shares for $50 will offset most, if not all, of it. Of course, if Stock A’s price continues to soar, you will let your option expire, in which case you will lose the entire amount you paid for the option. As an alternative, you could purchase a put option with a strike price of $45, which will lock in most, but not all, of your current gain. Because this would be an out-of-the-money option, the premium would not be as high, so you would not lose as much if the stock price continues to increase.
The above is an example of a protective put, which effectively reduces the risk associated with your stock investment. Some investors purchase puts solely in hopes of earning a speculative profit, however; they don’t own the underlying stock. For example, assume Stock B is currently selling for $48, which you believe is more than the stock is worth. You expect the market will soon recognize this and that its price will begin to fall. If you buy a put with a strike price of, say, $45, and the price of Stock B falls to $41 prior to the expiration of the put, you can earn a profit by then selling that put for at least its intrinsic value, which is equal to the strike price on the option minus the market price of the stock, or, in this example, $4 per option share ($45 - $41 = $4). Since a standard option contract is for 100 shares, this amounts to a tidy profit of $400 per put. As always, however, if you’re wrong and the price of Stock B increases, you will lose the option premium you paid when you purchased the put.
Writing Put Options
The put writer (seller) receives the option premium for the put, but then must stand ready to buy the underlying stock for the strike price on the option should the put owner decide to exercise his option. Some retail investors write puts in order to increase the income that their portfolio produces. Remember that a put option will be exercised when the price of the underlying stock falls below the strike price on the option, so the put writer is essentially betting that this won’t happen and that the option will expire worthless, leaving the writer to pocket the option premium as profit.
For example, assume you expect that Stock C, which is currently selling for $37 a share, will increase to $44 a share, so you sell a put on Stock C that has a strike price of $40.
If you’re wrong, of course, you may be forced to buy the stock, but you can also purchase a comparable put on the stock to limit your losses. Let’s say the price of the stock drops to $35 a share. The option premium for a put with a $40 strike price will increase since it is now even more in the money than when you sold it. Its intrinsic value alone is equal to $40 - $35 = $5. If it still has some time to expiration, you might have to pay, say, $7 per option share for it. Nevertheless, you will have limited your loss on the round trip to $300 since you received $400 when you sold the put and have bought a comparable put for $700 ($400 - $700 = -$300). Be aware that this won’t always be the optimal strategy; the market price of the underlying stock will determine whether it is better to buy a comparable put or take delivery of the stock.
Some investors will sell a put in an attempt to acquire a stock at a below-market price. For example, assume you have been following Stock D, which is currently selling for $60 per share. You would like to add the stock to your portfolio, but you think its price might drop a bit before it starts its climb, so you sell an at-the-market put (i.e., a put with a $60 strike price) for $2 an option share. If Stock D takes the slight dip in price that you expected—let’s say it falls to $59 a share—the put owner will exercise his option, forcing you to purchase the stock for $60. However, your effective cost will be the price of the stock less the option premium you received when you wrote the put, or $60 - $2= $58, which is less than the current market price of $59.
Not All Retail Investors Are Equal
With the exception of the protective put position, investors can lose a lot of money trading put options. Regulations require brokers to ensure that an investor has both sufficient net worth and knowledge before engaging in any kind of option transaction, and brokers have different levels of approval, which determine the types of option trades an investor can execute. You can buy a protective put with only a low approval level, but you will have to be approved at a higher level to engage in the other strategies discussed in this article.