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Put options are somewhat the opposite of call options. Using puts, it is possible to invest and benefit from declines in the stock market or in individual stocks. When you buy a put, you are forecasting that the stock’s price will fall in value before the put’s expiration date.
Buying puts is often compared to shorting a stock. But, although they are both bearish positions, buying puts is quite different. In fact, buying a put can be better than shorting the stock itself because your risk is limited to the amount you paid for the put option. If the market falls, both trades would be profitable … but if the market rises, your risk in a short stock trade is theoretically unlimited.
Buying Put Options
The process of buying a put is relatively simple. Typically, you want to find a stock in a firm downtrend that you feel is likely to remain in a downtrend. Once you have selected your “bearish” stock, buying a put works the same way as buying a call.
The chart below shows the iShares Russell 2000 ETF (IWM) from September 2007 through February 2008. IWM had been stuck in a dramatic downtrend and, by mid-February, was bouncing back down from a resistance level at $73 after a brief rise in January. This was a great candidate to for a put trade.
Running through a very similar trade entry process to the one that I discussed in the lesson on call options, we would start with buying a put with a strike price closest to the current stock price. Since the stock was priced at $70.18 at that time, the 70 strike with about 30 days left before expiration looked like an ideal candidate.
The 70 put would have cost $2.60 a share, or $260 per contract, on Feb. 14. In the chart below, you can see the stock subsequently dropped significantly, to $65 by March 10.
Assuming that you exited your trade at that time by selling the put at market value for $3.70 a share, or $370 per contract, you would have harvested a nice profit of $110. That’s a 42% return in less than 30 days.
1. Purchased 70 put on Feb. 14: $260
2. Sold 70 put on Mar 10: $370
3. Profit: $110
4. ROI: 42% (110 / 260 = .42)
As with call options, you have the ability to buy and sell put options before expiration. A put option will rise in value as the stock drops, and will decline in value as the stock rises. This gives you the flexibility as an option investor to take advantage of a volatile stock market.
In the video below, we will review how time value affects the growth of a put trade. We will also discuss the impact of increasing the time before expiration on the price of a put. There will be times, as a trader, when you will want more than 30 days before an option expires, but this will change the price of the option and is something that you will want to plan for.
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