Strategies in Buying Puts II
There are various strategies in handling your stocks that can both help you earn your profit but at the same time limit your losses by hedging. Some of these strategies involve buying puts. Just to review, a put is a kind of stock option that gives its holder the right to sell 100 shares of stock for a specified price, called a strike price, for a certain period. To be able to own this right, an investor must first pay a premium for the put, which is the price of the put option. This premium is often determined by the stock option market. One of the ways to minimize your losses as well as to insure that your stocks will be sold at a minimum selling price is to buy put options. I will discuss that stock strategy here. Note, however, that for purposes of simplicity tax considerations, commissions as well as transaction costs have been omitted in my illustrations. Also, the put options here are assumed to be American style, which means that the put option can be exercised any time before the expiration period.
This strategy will minimize your losses in case the prices of the stock you want to sell decreases and at the same time it does not prevent you from selling your stocks at a higher price in case of stock price appreciation. This strategy is commonly referred to as ‘married put’. To help you understand the married put strategy I have prepared an illustration for you. Let us assume that you have a feeling that in a matter of six months Stock B’s price would appreciate. Because of this you decide to buy 100 shares of Stock B at the prevailing market price of $40 per share. To insure that your 100 shares of Stock B would be bought for at least $40 per share, you bought a put option for a premium of $2 (or a total of $200 for all 100 shares). This put option will expire six months from now and you have the right to sell your 100 shares of Stock B for $40 per share. Let us assume that the price of Stock B rose to $50 per share before your put option expires. The current market premium for a put option decreased to $.90. You decide to sell your stocks in the stock market at $50 per share yielding a total profit of $800 which is the difference between the $5,000 you get from the sale, the $4,000 you used to buy 100 shares of Stock B and the $200 premium you paid for the put option. But to maximize your profits you can decide to sell your put option at $90 ($.90 x 100 shares) thereby making $90 more profit.
But suppose you were wrong with your prediction and instead of increasing, the prices of Stock B decreased to $30 per share. If you sell your stocks at the current market value you would have lost $1,000. Luckily you decided to hedge by buying a put option thereby insuring that you can sell your 100 shares of Stock B by at least $40 per share. If you choose to exercise your put option you would have only incurred $200 as cost instead of a $1,000 loss. By buying a put option you not only insured that the money you lose would only be the price of the premium, you also limit the risks you take in buying the 100 shares of stock.