Defining Put Profit Zones

To decide whether buying puts is a reasonable strategy for you, always be aware of potential profits and losses, rather than concentrating on profits alone. Comparing limited losses to potential profits when using puts for downside protection is one type of analysis that helps you pick value when comparing puts. And when looking for a well-priced speculative move, time to expiration coupled with the gap between current market value and striking price—which dictates the amount of time value premium—will help you to find real bargains in puts.

Premium level is not a reasonable criterion for your selection.

The profit and loss zones for puts are the reverse of the zones for call buyers, because put owners anticipate a downward movement in the stock, whereas call buyers expect upward price movement. See Figure for a summary of loss and profit zones and breakeven point using the following example.

[caption id="attachment_12478" align="aligncenter" width="342"]A put's profit and loss zones. A put's profit and loss zones.[/caption]


Canceling Out the Losses: You buy a put with a striking price of 50, paying 3. Your breakeven price is $47 per share. If the underlying stock falls to that level, the option will have intrinsic value of 3 points, equal to the price you paid for the put. If the price of stock goes below $47 per share, the put will be profitable point for point with downward price movement in the stock. Your put can be sold when the underlying stock's market value is between $47 and $50 per share, for a limited loss. And if the price of the stock rises above $50 per share, the put will be worthless at expiration.

Before buying any put, determine the profit and loss zones and breakeven price (including the cost of trading on both sides of the transaction). For the amount of money you will be putting at risk, how much price movement will be required to produce a profit? How much time remains until expiration? Is the risk a reasonable one?

Another example of a put purchase with defined profit and loss zones is shown in figure below. In this example, the put was bought at 3 and has a May 40 expiration. The outcome of this transaction would be exactly opposite for the purchase of a call, given the same premium, expiration, and price of the underlying stock. You will gain a profit if the stock falls below the breakeven point of 37 (40 strike less 3 premium).

[caption id="attachment_12479" align="aligncenter" width="304"]Example of put purchase with profit and loss zones. Example of put purchase
with profit and loss zones.[/caption]

Remember this rule: As a buyer, don't depend on time value to produce profits between purchase date and expiration because that is highly unlikely to occur. If you do not experience a price decline in the stock's price adequate to exceed the price you paid for the put, then you will have a loss. Like call purchasing, time works against you when you buy puts. The greater the gap between market price of the stock and striking price, the more time problem you will have to overcome.

The mistake made by many investors is failing to recognize what is required to produce a profit, and failing to analyze a situation to determine whether buying puts makes sense. Analyze these points in evaluating put buying:Collectively, these guidelines define an investment strategy and work for you as tools for evaluating risks and identifying profit potential. You could earn substantial short-term profits; you also face a corresponding high risk level represented by time, the buyer's enemy.

On the opposite side of the option transaction is the seller. Unlike buyers, sellers have an advantage with pending expiration. Time is the seller's friend, and higher time value represents an opportunity rather than a risk. Because time value declines as expiration approaches, the seller benefits in the same degree as the buyer is penalized. You can purchase puts or sell calls and achieve the same strategic position, but the risks may be far different. Calls offer some interesting strategic possibilities for sellers, both high risk and very conservative.
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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