Bear markets and price corrections have plagued stock prices since the dawn of our modern marketplace. While it would be delightful to ban the volatility beast once and for all from Wall Street, such a fantasy only exists in the profit-filled dreams of perma-bulls.
Fortunately, educated investors have a number of weapons at their disposal to not only survive the occasional volatility attacks, but profit from them. Indeed, some skilled traders look forward to bear markets with downright giddiness as that’s when their bearish strategies really score.
Chief among these traders’ profit generating tactics is buying put options.
Perhaps you’ve heard of the puts bullish counterpart, the call option. While call options give you the right to buy stock, put options give you the right to sell stock. Here’s the full definition:
A put option gives the buyer of the contract the right, but not the obligation, to sell 100 shares of stock at a specific price on or before an expiration date.
This right to sell a stock at a set price becomes increasingly valuable as the stock price falls further and further. Let’s say Apple Inc. (NASDAQ:AAPL) is perched at $150 and I buy a three-month put option giving me the right to sell 100 shares of AAPL at $150. If AAPL stock were to fall to $130, then having the right to sell the stock back up at $100 would become quite attractive.
This is why buying put options is touted as a bearish trade and can produce big profits when stocks tank.
When you really begin to dig into the world of buying puts, you’ll discover they are quite the alluring alternative to shorting stock. Buying a put is a heck of a lot cheaper and offers a fair bit more leverage. Plus, you don’t have to borrow shares of stock to initiate your position.
The first step to buying put options is identifying a stock you believe will fall in value. Then, determine how long you plan on being in the position. Because options have an expiration date you have to choose how much time to buy.
Let’s say I think Wal-Mart Stores Inc (NYSE:WMT) is going to drop over the next two months. Rather than simply buying a two-month put option, try grabbing an extra month or two for good measure. It’s always better to have too much time rather than too little. Plus, you will limit the effect of time decay by using longer-term options.
The next choice involves selecting which strike price to buy. Buying in-the-money put options is more conservative so consider starting there. In-the-money puts are those with a strike price above the stock price. With WMT sitting at $75 we could buy a three-month $77.50 put for $3.20. Since put prices are listed on a per share basis, the $77.50 put would cost a grand total of $320, or $3.20 times 100. The initial cost also represents the max risk in the position.
The reward for buying put options is limited only by the stock falling to zero. Just like a stock trade, the objective of our put option play is to buy low and sell high. A big enough drop in WMT stock could send our $3.20 put option to $5, $6, $7 or even higher.
Once the stock has made the forecast drop, exit gracefully with profits in tow. Simple as that.