Mention call and put options and you can watch eyes begin to glaze over around the room. Option trading is an entire world to it’s own but, if you have at least a moderate ability to understand the stock market, you should be able to wrap your mind around how to integrate a put option strategy into your trading portfolio. There are two basic ways you can approach a put option.
Use put options as a trading strategy to generate profits.
Implement put option positions as a hedge against drastic market moves against your stock holdings.
Put Options Basics
Options that are traded on exchanges are a different beast than those issued as part of an employee compensation program. Normally the latter are good for years, plus you don’t have to pay anything to get them. The type of put option strategy we’re talking about is much shorter term in nature – they will likely expire in a few months – and you have to pay something to get them, just as if you were buying stock. A single put option contract allows you the right to buy 100 shares of the underlying stock at a certain price within a certain time frame. Terms like strike price, premium, expiration date, in the money, at the money, and out of the money are good to know.
Premium — The price of the option; the price the buyer pays and the seller receives. The premium can be broken down into two parts: The intrinsic value and the time value.
Strike Price — The price at which the put owner has the right to sell the underlying stock.
Expiration — The last date the option is a valid contract. Technically, options expire on the Saturday
following the third Friday of the month. But the last day to trade them is the third Friday of the expiration month. Many index options will expire one day earlier on Thursday. You can describe an option in one of three ways, depending on the relationship between its strike price and the value of the underlying stock …
In the money: When the strike price of a put option is higher than the price of the underlying instrument, the option is in the money.
At the money: When the strike price is essentially equal to the price of the underlying instrument, the put option is at the money. When expiration day arrives, options that are in the money have value and you can sell them at a price that’s very close to that in-the-money value. Before expiration, you also can capture any remaining time value in the options.
Out of the money: When the strike price of a put option is lower than the price of the underlying, then
the option is out of the money. When expiration day arrives, options that are out of the money expire
But why do investors like options, when they could just as easily buy the underlying stock? Here are 5 reasons: Let’s ask Mike Larson who explained it quite well in his report, The Great American Apocalypse of 2011 – 2012.
Advantage #1. Leverage. Even a modest move in an underlying stock can result in a significant change in the value of your options.
Advantage #2. Limited risk. With the simple purchase of options (as long as the options are not exercised), you can never lose a penny more than you invest plus commissions. That means you always know how much money you have at risk.
Advantage #3. Low cost. You can find options with excellent potential that cost as little as $50 or $100 per contract, although some options may cost $1,000 or more per contract.
Advantage #4. Listed on exchanges. Thousands of options are listed on regulated exchanges. You don’t need to venture into so-called over-the-counter options to generate substantial profits in the Great American Apocalypse of 2011-2012.
Advantage #5. An excellent vehicle for protective “hedges” against market declines. As we mentioned above, options can be used as a kind of insurance policy or hedge.
As you should know if you’ve been around the block a time or two, few things in this life come only with advantages and no disadvantages. Such is the case with a put option strategy. Here are four potential drawbacks listed by Larson.
Disadvantage #1. Options are wasting assets. That’s because when you buy an option, you are buying time. So if the market remains unchanged, the value of the option will naturally decline as time
Disadvantage #2. Limited time. This follows from the first disadvantage. The expected market move has to take place — or at least get underway — before the option expires. Otherwise, the option can expire worthless and you will lose the entire amount you invested in that option. That’s why it’s important to buy an option with enough time for your trade to work out.
Disadvantage #3. Volatility. Investors who buy options and just forget about them often miss out on
take large profits. Sometimes the option’s value will spike upward, and then, before
you know it, plunge back downward again.
Disadvantage #4. Occasional low liquidity. There are many options with plenty of liquidity. But there are also some that are not so liquid. In other words, the number that change hands in a given day (the volume) is low and the total amount held by investors (the open interest) is small. These options tend to have wider spreads, or differences between the bid and ask prices. That can result in you getting poor execution on your trades — paying more than you should to buy and getting less than you deserve when it’s time to sell.
Buying or selling a put option outright without owning the underlying stock is a pure speculation play, much the same as if you had simply bought the stock. EXCEPT the very nature of options means that leverage works in your favor, allowing you to control more value with less money. On the other hand, if you implement a put option strategy merely to hedge your stock positions, consider the premium you pay as the cost of insurance, because that’s basically what it is. Hopefully, the market never moves against your stock positions and the options expire worthless.
It makes sense for a new investor to spend a bit of time understanding the option market. There’s a good chance you’ll find yourself unavoidably drawn to it at some point in your investing career. Maybe you’ll give it a fling and move on to another type of investing that fits your personality better, or maybe you’ll fall in love with the whole ‘magnification of profits through leverage’ thing. Either way, DO NOT jump into option trading until you actually understand what is going on. From personal experience we know that you can get your head handed to you on a silver platter.
The Young Wealth Team
(Flickr / Doc Trader)