Buying Puts: The Positive Side of Pessimism

Do you believe the market is headed down? If so, puts could serve as a valuable weapon in your pessimistic market strategy.

Call buyers acquire the right to buy 100 shares of an underlying stock. In contrast, a put grants the buyer the opposite right: to sell 100 shares of an underlying stock. Upon exercise of a put, the buyer sells 100 shares at the fixed contract price, even if the stock's current market value has fallen below that level.

It is easy to get confused because calls and puts are opposites.
In other words, if the underlying stock's value goes down, the put's value goes up. The put works in the other direction. So buying puts, which can be done for several reasons, is an action you will take if you expect declining stock prices; if you want to protect a long stock position in the event of a decline in price; or when entering a more advanced strategy combining puts with calls -- more on all of this later.

As a put buyer, you have a choice to make in the near future. You may sell the put before it expires; you may exercise the put and sell 100 shares of the underlying stock at the fixed striking price; or you may let the put expire worthless.

You are not obligated to sell 100 shares by virtue of owning the put. That decision is entirely up to you, and is a right but not an obligation. The seller, however, would be obligated to buy 100 shares if you did decide to exercise the put.

Smart Investor Tip

The buyer of an option always has the right, but not the obligation, to exercise. The seller has no choice in the event of exercise.

As a put buyer, your decisions will depend on the same features that affect and motivate call buyers:Additionally, the same rules apply to puts and to calls regarding the trend in extrinsic value. If you make a distinction between extrinsic and time value, you will recall the important rule: Time value declines over time and is a factor strictly related to the time remaining until expiration. Extrinsic value (usually included as part of time value in a discussion of option valuation) is more complicated.

Extrinsic value, the non-intrinsic portion of option value not related solely to the time element, is affected by numerous things, including:
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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