Put options are basically the opposite of call options, when you purchase a call option somebody else has taken out a put option to cover the other side to your trade. If your trade makes money, he loses and vice versa.
So how do put options work? Naturally they’re similar to call options. But there are a number of different ways to use them. So let’s take a look at a typical put option trade first, then we’ll look at ways to implement them into your trading strategy.
Put Option Example
Lets say you,”Trader A”(Put Buyer) purchase a put contract to sell 100 shares of XYZ Corp. to “Trader B” (Put Writer) for $50 per share. The current price is $55 per share, and you Trader A pay a premium of $5 per share. If the price of XYZ stock falls to $40 a share right before expiration, you can then exercise the put by buying 100 shares for $4,000 from the market, then sell them to Trader B for $5,000.
Your total earnings (S) can be calculated at $500. The sale of 100 shares of the stock at a strike price of $50 to Trader B = $5,000 (P). The purchase of 100 shares of stock at $40 = $4,000 (Q). The put option premium paid to trader B for buying the contract of 100 shares at $5 per share, excluding commissions = $500 (R). Thus S = P – (Q+R) = $5,000 – ($4,000+$500) = $500.
If, however, the share price never drops below the strike price (in this case, $50), then you would not exercise the option (because selling a stock to Trader B at $50 would cost you more than it would cost to buy it). Your option would be worthless and you would have lost the whole investment.
Use Put Options to Hedge Your Investment Portfolio
Using put options to hedge your investment portfolio is the perfect strategy; most professional hedge fund manager’s this strategy to hedge open positions.
Hedging is using options to counteract price movements in your main portfolio. Let’s say you have a large holding of Microsoft stock, but due to a particularly weak trading period before the launch of Windows 8, the stock is trading down.
In this case you wouldn’t want to sell your MSFT holdings since the long term outlook remains good. So you could use put options to offset the short term drawdown.
This will make your investment strategy much more profitable in the long term, as you’ll be hedging your open positions to offset losses in the short term.
Put Option Strategies
Covered Puts – The covered put strategy is a hedging strategy that should be used in a bearish market.
Basically you short shares in an underlying asset and then sell put options against them in order to profit from a bearish move.
Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.
You can find out more about covered puts in this article.
Naked Puts – Naked puts, sometimes called uncovered puts are put options where the seller does not have a position in the underlying stock. This strategy is best used by investors who want to accumulate a position in the underlying stock – but only if the price is low enough.
Naked puts are considered to be very risky and your broker may not allow you to trade them or require much higher margin requirements. But if you’re sensible they can be very profitable.
Where to Start?
If you’re new to options you need to be careful which broker you choose, options trading is very risky and can result in significant losses for the unwary. So choosing the right broker is imperative for your trading success.
It’s no good just going for the broker with the lowest commissions. Training and support are much more important when you’re just starting out.
For this reason we recommend rookies start trading with either optionsXpress or OptionsHouse, since both brokers offer excellent support and training as well as intuitive platforms and reasonable commissions.
Successful options’ trading is difficult and will require a small amount of dedication on your part, don’t make the mistake of hampering your success by using a broker that doesn’t have a vested interest in you succeeding.
Cheap commissions come at a cost and you’ll end up paying more in the long run.