A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to short sell stocks . The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock price rises.

But when you use puts as an alternative to short stock , your risk is limited to the cost of the option contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you would with short stock. You simply allow your puts to expire worthless or sell them to close your position (if they’re still worth anything).

Be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment.

Puts can also be used to help protect the value of stocks you already own. These are called protective puts.

 

Maximum Potential Profit

There’s a substantial profit potential. If the stock goes to zero you make the entire strike price minus the cost of the put contract. Keep in mind, however, stocks usually don’t go to zero. So be realistic, and don’t plan on buying an Italian sports car after just one trade.

 

Maximum Potential Loss

Risk is limited to the premium paid for the put.

 

Break-even at Expiration

Strike A minus the cost of the put.

 

Credence Global Bank Invest Margin Requirements

After the trade is paid for, no additional margin is required.

 

Time Decay

For this strategy, time decay is your enemy. It will negatively affect the value of the option you bought.

 

Implied Volatility

After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is down).

 

Final Thought

Don’t go overboard with the leverage you can get when buying puts. A general rule of thumb is this: If you’re used to selling 100 shares of stock short per trade, buy one put contract (1 contract = 100 shares). If you’re comfortable selling 200 shares short, buy two put contracts, and so on.

You may wish to consider buying an in-the-money put, since it’s likely to have a greater delta (that is, changes in the option’s value will correspond more closely with any change in the stock price). Try looking for a delta of -.80 or greater if possible. In-the-money options are more expensive because they have intrinsic value, but you get what you pay for.

Learn More About Credence Global Bank Invest