Aput is anoption contract that gives the owner the right, but
not theobligation , to sell 100shares of the underlyingstock at a
specified price (which is known as thestrike price of the put) at
any time before a specific time (theexpiration date of the
Bearish traders would useputs because the value of the put
should go up if the price of the underlying stock goes down. The
potential profits for a trader owning a put are significant, but
are limited because the underlying stock can not fall below zero.
This is different frombullish option trades that usecall contracts
and have unlimitedprofit potential. The maximum possible risk on a
put is limited to the total price paid for the option contract.
Changes in the price of the underlying stockwill lead to a
change in the value of the put, as will changes in the volatility
of the underlying stock. If the stock becomes more volatile, the
put should go up in price because there is a greater chance that it
will reach the strike price by theexpiration date . Falling
volatility lowers the chance that the underlying stock will fall
enough to reach the strike price and that should decrease the value
of the put.
In addition to being driven by the price and volatility of the
underlying stock, the put will also change in value based on how
much time is left until the expiration date. The put will be less
valuable as it gets closer to the expiration date.
How traders use it
A trader who is bearish on a stock orindex could buy a put. There
are also option contracts available on some
andfutures . Traders can use puts on a number of individualstocks ,
indexes like the S&P 500, or ETFs like the
SPDR S&P 500 (
. A put is a leveraged trade that gives the trader a chance to
enjoy relatively large rewards for a defined amount of risk.
As an example, consider
. If Apple is trading near $600 a share, 100 shares would
cost $60,000. A trader who thinks Apple will fall could
sell the stock short, but that would require a large amount
ofmargin and the risk a trader faces in a short position is
unlimited. Instead of selling Apple short, a trader could
buy a put contract.
If traders think Apple should fall within the next few
weeks, then they could buy aput option that allows them to sell 100
shares of Apple for $600 (the strike price) at anytime in
the next two months (the expiration is 60 days away) for a price of
about $32 per share (the option premium). This would allow them to
participate in any price decline while limiting their risk to only
If Apple fell to $500 a share at the expiration date,
the traders would make $6,800. This assumes that traders could sell
short the 100 shares for $600 and immediately buy them back in
themarket for $500. The premium of $3,200 would be deducted from
the profits. Put traders can close their positions by selling a put
contract without having to sell the stock short first and then buy
it back. The profits would be the same. The options trader would
make a return of 112% on theirinvestment .
If Apple closed above $568 on the expiration date, the
trader would suffer a loss of their entire investment since selling
short to cover the put contract and buying the shares back to close
the short position would not cover the cost of the premium. However
the trader's loss is limited to $32 per share no matter how
high Apple goes. If the stock rises to $700, then the
trader who shorted 100 shares would lose $10,000 while the put
holder would only lose $3,200.
The actual price move in Apple would determine the
price of the option. Puts can be bought or sold at any time and the
trader would be able to take a profit or cut their loss at any time
during the trade.
Action to Take -->
Puts can be used as part of a trading strategy to profit in bear
markets with limited loss potential. Traders who are bearish in the
short-term can use puts to create short positions at a lower cost
than selling individual stocks short. Puts also havelimited risks
while short positions carry unlimited risks for traders. Long-term
options are available and traders can use them to create low-cost,
longer-term short positions in a stock.
This article originally appeared on ProfitableTrading.com:
Put Options: Profit From Falling Stocks Without
Taking on Unlimited Risk
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