Strategies in Buying Puts III
Other than to profit in the decrease of stock prices as well as to minimize losses in case of a stock price increase, one can also buy puts as a form of strategy to protect a long position from short periods of stock price decline. A long position in puts means that an investor has bought more put options for a particular series of options as compared to the number of put options he sold. To understand an option series one has to understand a class of options. Option contracts that are of the same type, which means either put or call, and the same style, which can be American, European or Capped, and which covers the same underlying stock, is called a class of options. A series of stock options cover a class of options that have the same strike price, expiration date and unit of trade. To understand this strategy I will utilize an illustration. 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.
Let us assume that by virtue of a call option or by some other means you were able to buy 100 shares of Stock B for only $60 per share. The current market value of Stock B is for $75 per share. You are not sure whether the stock price of Stock B would continue to increase or decrease so you decide to buy a Stock B 70 put option with a premium of $1.50. This means that by paying the total $150 premium you are assured that at your instance, you can sell your 100 shares of Stock B for $70 each for a total of $7,000. You are also assured that the loss that you would incur would only amount to $150, the price you paid for the premium. Let us assume that the stock prices of Stock B decreased before your put option expired. The premium of a put option however increased to $6. You have two choices. You can either choose to exercise your put option and sell your 100 shares of Stock B for $70 per share garnering a total profit of $850 which is the difference between the $7,000 you sold your 100 shares, the $6,000 for the amount you bought your 100 shares and the $150 premium for the put. If you decide, however, to keep your 100 shares of Stock B in the hopes that the stock prices would increase in the future, you can choose not to exercise your put option and sell your put option instead at the prevailing fair market value of put option at $600 (for 100 shares). In this scenario you can earn $450 as profit which is the difference between the $600 and the $150 as premium. You also get to keep the 100 shares of Stock B. With this strategy you can protect yourself from any stock price decline and limit your losses to only the amount of the premium. You can also choose to just sell the put option to still earn profit and sell your shares of stock at a later date.