The Limited Life of the Put
If you believe the underlying stock's market value will decline in the near future, you can take one of three actions in the market: sell short on shares of the stock, sell calls, or buy puts. When you buy a put, your desire is that the underlying stock value will fall below the striking price; the more it falls, the higher your profit. Your belief and hope is opposite that of a call buyer. In that respect, many people view call buyers as optimists and put buyers as pessimists.
Your risk is limited to the premium paid for the put. As a put buyer, you face identical risks to those experienced by the call buyer. But when compared to selling short 100 shares of stock, put buyers have far less risk and much less capital requirement. The put buyer does not have to deposit collateral or pay interest on borrowed stock, is not exposed to exercise as a seller would be, and does not face the same risks as the short seller; yet the put buyer can make as much profit. The only disadvantage is the ever-pending expiration date. Time works against the put buyer, and time value premium evaporates with increasing speed as expiration approaches. If the stock's market value declines, but not enough to offset lost time value in the put, you could experience a loss or only break even. The strategy requires price drops adequate to produce a profit.
Compare the various strategies you can employ using shares of stock or options, depending on what you believe will happen in the near-term future to the market value of the underlying stock:
|You believe that the market will:|
|Stock strategy||Buy shares (long)||Sell shares (short)|
|Option strategy (long)||Buy calls||Buy puts|
|Option strategy (short)||Sell puts||Sell calls|
ExamplePerfect Timing: You have been watching a stock over the past few months. You believe it is overpriced today, and you expect market value to decline in the near term. Originally, you had planned to buy shares, but now you think the timing is wrong. Instead, you borrow 100 shares from your brokerage firm and sell them short. A few weeks later, the stock has fallen 8 points. You close the position by buying 100 shares. Your profit is $800, less trading costs and interest.
ExampleLimiting Risk Exposure: You believe that a particular stock's market value will decline, but you do not want to sell short on the shares, recognizing that the risks and costs are too high. You also do not want to sell a call. That leaves you with a third choice, buying a put. You find a put with several months until expiration, whose premium is 3. If you are right and the stock's market value falls, you could make a profit. But if you are wrong and market value remains the same or rises (or falls, but not enough to produce a profit), your maximum risk exposure is only $300.
The limited loss is a positive feature of put buying. However the putâlike the callâexists for only a limited amount of time. To profit from the strategy, you need to see adequate downward price movement in the stock to offset time value and to exceed your initial premium cost. So as a put buyer, you trade limited risk for limited life. If you use long-term equity anticipation security (LEAPS) puts, premium costs will be higher, but you also buy more time; so for some speculators, the LEAPS put is a viable alternative to the short-term listed put.
Smart Investor TipAs a put buyer, you eliminate risks associated with going short, and in exchange, you accept the time restrictions associated with option long positions.
You can view a LEAPS put in terms of risk in one of two ways. Of course, the extrinsic and time value problems and opportunities remain as they do with all options. But the extended period of time has an offsetting element to remember. First, you pay more for the additional time. Second, your risk is reduced because the added time provides more opportunities for favorable price movement. Thus, potential profits are improved for higher initial option premium cost. For anyone purchasing puts, this trade-off is the ultimate judgment call. You seek bargain prices, but you also seek the most time. So the offset between opportunity and risk is defined by the offset between time and cost.
ExampleThe Time-versus-Cost Decision: You want to buy a put on Motorola (MOT) in the month of December. You review three different possibilities, those expiring in four months (April), in 13 months (the following January), and in 25 months (January a year later). At the time, Motorola's market value was $20.67 per share. The put values were:
|Put Striking Prices|
|Striking Prices||4 Months||13 Months||25 Months|
If you were inclined to invest in a long put on this stock and favored in-the-money puts, the 30 is more expensive, but the extrinsic value is very low. If you were to select the 25-month put rather than the 13-month put, the added cost would be only $10, the difference between 9.65 and 9.75. In other words, for only $10, you "buy" an additional 12 months in the put, giving you that extra year of potential. Thus, if Motorola were to decline several points over 25 months, this added cost provides you with much greater potential for profit. The 25 put can be subjected to the same argument, with the added cost only $20, the difference between 4.80 and 5.00.
The point to this comparison is that the farther away from striking price, the smaller the increments in extrinsic value. This gives you the opportunity to extend the put's lifetime for very little added cost.
Put buying is suitable for you only if you understand the risks and are familiar with price history and volatility in the underlying stock, not to mention the other fundamental and technical aspects that make a particular stock a good prospect for your options strategy. Without a doubt, buying puts is a risky strategy, and the smart put buyer knows this from the start.
ExampleCalling the Market Correctly: You have $600 available and you believe that the market as a whole is overpriced. You expect it to fall in the near future. So you buy two puts at 3 each. The market does fall as expected; but the underlying stock remains unchanged and the puts begin to lose their time value. At expiration, they are worth only 1.
In the preceding example, it appears that the strategy was inappropriate. First, capital was invested in a high-risk strategy. Second, the entire amount was placed into puts on the same stock. By basing a decision on the overall market trend without considering the indicators for the specific company, you lost money. It is likely, too, that you did not understand the degree of price change required to produce a profit. If you do not know how much risk a strategy involves, then it is not an appropriate strategy. More study and analysis is required.
Smart Investor TipWhen it comes to market risk, the unasked question can lead to unexpected losses. Whatever strategy you employ, you need to first explore and understand all of the risks involved.
Once you understand the risks and are convinced that you can afford the losses that could occur, you might decide that it is appropriate to buy puts in some circumstances. Remember, though, that the evaluation has to involve not only the optionâpremium level, time value, and time until expirationâbut also the attributes of the underlying stock.
You are aware of the difference between long-term investment and short-term speculation in the preceding example. You have established a base in your portfolio, and you thoroughly understand how the market works. You can afford some minor losses with capital set aside purely for speculation. Buying puts is an appropriate strategy given your belief about the market, particularly since you understand that stocks in your portfolio are likely to fall along with broader market trends. Your ability to afford losses, and the proper selection of stocks on which to buy puts, add up to a greater chance of success.