Buying Puts: The Positive Side of Pessimism
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.
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.
As a put buyer, your decisions will depend on the same features that affect and motivate call buyers:
Smart Investor TipThe buyer of an option always has the right, but not the obligation, to exercise. The seller has no choice in the event of exercise.
- Price movement in the underlying stock and how that affects the put's premium value.
- Your motives for buying the put, and how today's market conditions meet or do not match with those motives.
- Your willingness to wait out a series of events between purchase date and expiration and see what develops, versus your desire for a sure profit in the short term.
Extrinsic value, the non-intrinsic portion of option value not related solely to the time element, is affected by numerous things, including:
- Volatility of the underlying stock. The more volatile the stock, the greater the related volatility in extrinsic value. This is especially applicable when the stock's price is erratic and chaotic.
- Trading range of the stock. A fairly narrow trading range tends to hold down extrinsic value, but when a stock's market value moves back and forth within a broader trading range, that will be reflected in greater extrinsic value. (This is not the same as volatility of the underlying stock. A volatile stock is erratic and unpredictable. A broad trading range may remain predictable but with greater distance between its likely high and low price range.)
- Breakout from established trading range. When a stock's price moves above or below an established trading range, option extrinsic value will increase as well. Depending on whether movement means that puts (or calls) go in the money, the increased intrinsic value may also be augmented with greater extrinsic (nontime) value within the same trend.
- Proximity between current market value of stock and striking price of the put. When the two are within close proximity, extrinsic value -- which you might think of as potential for increased value in the future -- will be greater as well. This is especially true when the put is out of the money but the stock's current market value is three points or less above the striking price.
- The time element. While extrinsic value is distinguished from time value, it is going to vary based on (1) time itself and (2) the other considerations listed here.
By Michael C. Thomsett