Strategies in Buying Puts I
You might be wondering how one can benefit from buying puts or if ever there can be any benefit at all in buying puts. Well, I’ve got news for you, you can profit in buying puts and I am here to show you how. Note, however, that for purposes of simplicity, tax considerations, commission, as well as transaction costs have been omitted in my illustrations. Also, the call options here are assumed to be American style, which means that the call option can be exercised any time before the expiration period.
First of all, buying puts are more advisable and less risky than shorting stocks outright as you know that the amount of loss you incur will only be the amount of the option premium you paid. In shorting stocks, the amount of loss you may have can be potentially unlimited. To recap, when you buy put options you have the right to sell 100 shares of stock at a specified time within a specified period. This means that with a put option you can obligate the writer to buy your stocks at a specific price. Your hope is for the stock prices to fall so that you can sell your stocks at a higher price than the market price. You can profit from buying puts by taking advantage of the price decrease in the stock.
Assuming that you buy a Stock B July put 50 at the option premium of $4. This means that for the price of $400, you can obligate the writer to buy your 100 shares of Stock B for $50 each until the expiration on July. Let us assume that before July approaches the stock price of Stock B falls to $45 per share and the prevailing option premium for put options in Stock B rose to $6. You have two options to benefit from the price decrease in Stock B. You can choose to buy 100 shares of Stock B at the prevailing price of $45 (for a total of $4,500) and exercise your put option and sell the same 100 shares of Stock B for $50 per share (for $5,000 in all). If you do this you stand to gain a total of $100 which is the difference between the $5,000 (as proceeds from the put option) minus $4,500 (market price of 100 Stock B) minus $400 (premium for the put). Other than exercising your put option you can also sell your put option contract with the premium of $6 garnering total profits of $200 which is the difference between the new premium $600 minus the old premium $400.
Let us assume that instead of decreasing, the stock price of Stock B increased to $55 per share and the premium for the put option contract decreased to $1.50. To minimize your losses you can sell your put option at the prevailing price for $150 garnering only a loss of $250 ($400 – $150). Had you chosen to short the stocks and the stock price rose to $55 per share you would have lost $500 ($5,500 – $5,000). This only goes to show that buying call options is more profitable and less risky than shorting stocks outright.