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What are put options? How to buy put options? How to sell put options?
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Buying Puts
But suppose you look at XYZ stock and think to yourself, “Now there’s a train wreck waiting to happen.” You can see that the price is going down soon -- but how can you make a profit when a stock loses value?
A put option allows you to do just that. It’s basically buying a call option in reverse. Let’s say that XYZ stock is trading for $10 a share in June. You just know in your bones that it’s going to tank by August. You buy the XYZ August $12.50 put option for $2 a contract. Your $200 now buys you the right to sell, or put, 100 shares of XYZ, at $12.50 a share, anytime before the third Friday in August. You do this because you fully expect it to drop like a stone – possibly all the way down to zero.
Let’s say you were right on the money. XYZ is a dog and falls to $5 a share. You can exercise the put and sell 100 shares of XYZ at $12.50 – then buy 100 shares of XYZ at the current price of $5 for a profit of $7.50 per share, minus the $200 you paid for the option, and commissions. Unlike a call option, in which you first buy and then sell, those who exercise put options sell the stock first -- and then buy the stock back at a lower price to complete the transaction. If you don’t want to hassle with buying and selling
stock, you may simply choose to sell the put options, which rose in value when the price of the underlying stock fell.
But here’s the corresponding risk: say you buy one XYZ August $12.50 put contract at $2. A week later XYZ shoots up to $15 a share. You’re now in the red, and your losses only mount as XYZ continues to climb. You must then sell your put option at a loss or let the contract expire worthless.
Selling Puts
Say it’s June, and you own 100 shares of XYZ stock, which is stuck at $10. The market is stable and you’re pretty sure XYZ is on its way up soon, but it isn’t going anywhere at the moment. You’d like to make some money off XYZ while you wait for the move, but you don’t want to sell a call option, since you believe the stock may rise in price. You see that the XYZ August $10 put options are selling for $2. You sell one put contract and receive a $200 premium from the put buyer.
If XYZ rises above $10, you keep both your stock and the $200 premium, since you’re unlikely to get called out when your stock is at, or above, the put strike price.
If, however, you misjudged either the market or XYZ, and the stock falls below your strike price of $10, the option may be exercised, and you may be forced to buy 100 shares of XYZ stock at $10 a share. The amount of your loss will then depend on how low XYZ falls before you can sell it and get out of the trade.
Summary
As you can see, options are versatile investments. These examples are only the most basic of the potential options trading strategies available. It’s important to note that since options are perishable commodities, and since it’s possible to lose money with them very quickly, it’s not advisable to trade them until you have a good grasp of what they are and how they work.
Related Articles: Buying and selling call options,
Best brokerages for Options Trading in 2012
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