By: Chris Rowe — October 1, 2019
Buying puts is similar to "shorting" a stock (which is betting on the stock trading lower by selling it first, and buying it back at a cheaper price). Instead of shorting the stock directly, you are purchasing an option "contract" that gives you the right (but NOT the obligation) to short the stock.
Two week’s ago, I illustrated the advantage of buying puts over short selling stock.
Recall we said that using options can be more profitable and less risky than selling tock short in order to profit in a downward market.
I also promised you my three rules for buying puts safely.
So here they are.
Always remember that each option contract represents 100 shares of stock. So five options contracts represent 500 shares... 10 contracts represent 1,000 shares and so on.
If your put option goes from $7.00--$8.00, the value of the contract will go from $700.00--$800.00.
The most important thing to remember is that if you would only be willing to risk selling-short 500 shares of a $40.00 stock, you should only buy five put options on that same exact stock and nothing more.
You must also remember that you're taking a conservative approach -- using an options strategy -- in an effort to reduce your risk.
In other words, 500 shares of a $40.00 stock is a $20,000.00 trade. If you would normally risk selling 500 shares short, then you certainly should NOT buy $20,000.00 worth of put options (which is a common and sometimes very tempting mistake to make).
It's called "overleveraging" and it's something you never want to do.
Instead, if the put option is quoted at $7.00 (each contract representing 100 shares of stock which means it will cost $700.00 per contract,) then you should buy five put options (representing 500 shares) which would cost you $3,500.00.
What do you do with the remaining $16,500.00 out of the $20,000.00 that you would have used to short the stock? (Remember, we only used $3,500.00 on five puts at $7.00.)
LEAVE IT IN CASH! Consider it part of this trade - the capital that is impossible to lose (which is pretty much the case.) Reserve it for when you want to trade stock again. Don't use this remaining capital, not even to buy other options.
In June I wrote an entire column on this very topic ("The Best Trading Advice You'll Ever Receive"). At the time, I said "If you don’t feel that you have overwhelming odds of success, then don’t get involved. Think about it: if you are sitting on cash instead of stock while the stock market moves 8% lower, then you’ve just beaten the market by 8%!"
That same principle applies here.
What do I mean by that?
Let's say that a stock that you think is going to trade lower is at $40.00 per share. You may have several puts to choose from. For example study the hypothetical Option Chain below...
The April 45 put is in the money by five points, because the stock is at $40.
In other words, say I own a put option contract that gives me the right to sell XYZ stock at $45. And say the stock is trading at $40. I could make a five-point profit on the difference between the sell and the buy were I to execute both trades simultaneously.
Notice that the April 45 put is trading at $5.65. Now as I mentioned, the option is five points in the money -- it's worth at least $5.00 per share. So why is the option trading at $5.65 and not just $5.00?
In that $5.65 put option, $5.00 which is in the money is called the "intrinsic value." The remaining 65 cents is called "time value.
The put option is considered to have additional value since it won't expire for another six months. If your stock trades in the wrong direction, you have the luxury of six months to wait it out, and see if the stock does what you want it to.
The longer your option has until expiration, the more time value may be included in the price of the option.
For example, an XYZ year 2021 January 45 put (which expires nine months later than the example above) might be trading at $6.65 ($1.00 more than the example above) which would mean that it has $1.65 in time value and still has $5.00 intrinsic value -- it's still five points in the money.
To find a put option that's in the money, and determine by how much, first look for put options that have a strike price that is higher than the actual stock price. Then, subtract the stock price from the strike price of the option.
(If the strike price of a put is lower than the stock price, it is not "in the money"; it's "out of the money”.)
In this case: XYZ stock is at $40, so we look at the 2020 April 45 put since that strike price of $45 is higher than the stock price.
$45 (the strike price) -$40 (the stock price) = $5 (intrinsic value, or in the money.)
Since the option is trading at $5.65, we know that the remaining $0.65 is the time value. The idea is to use a put option that has very little time value so that your trade is almost solely affected by the stock's price movement and not time deterioration.
Your put option will lose its time value as you get closer to the expiration date. Picking a put option that will give you twice as much time as you believe you need for your position to work out is also usually a wise idea. Trades often don't go exactly as you expect them to, so you want to have a (time) cushion.
Following these three rules when purchasing put options can help preserve your portfolio, reduce your risk, and even make a profit in a downward market.
Take care, and stay safe!