Recently, we discussed buying call options or initiating bull call spreads if it appears an underlying stock will move up. This week, we will discuss the opposite; how buying put options can help you get the most out of a stock’s downturn.
What is a Long Put?
For “vanilla” bears, buying a put option on an equity is an attempt to profit from its predicted decline. A put option affords the trader the right to sell 100 shares of the underlying stock at the strike price of the contract, should the shares fall below the strike prior to the option’s expiration date.
In the same way that call options provide leverage over buying a stock outright, long puts offer leverage compared to shorting a stock. The initial premium paid for the put represents the maximum loss on the trade, where unhedged short selling poses the risk of theoretically unlimited losses. In addition, a put buyer can achieve a greater return on investment compared to a short seller.
Here’s an Example:
Let’s revisit our favorite trader, Trader A. Trader A is bearish on stock XYZ, which is showing fundamental and technical weakness amid high expectations. XYZ is trading at $45 per share, but trader A thinks it is due to fall in the coming months. Instead of selling the shares short, trader A buys to open one June 50 put option on XYZ, which is asked at $5.55. The cost of this option contract is $555, as one contract represents 100 shares of the underlying. That’s opposed to the short seller — or Trader B — who would be on the hook for $4,500 to short 100 shares of the stock outright.
Trader A will profit if XYZ finishes below its breakeven point by the time June expiration rolls around. The breakeven point of the purchased put option is the strike price minus the net debit; $44.45 in this scenario. The extent of the profit is determined by how much the shares fall by the expiration date. If XYZ fell to $40 by the expiration date of June 16, the 50-strike puts would have an intrinsic value of 10 points, or $1,000. Minus the $555 paid for the put, that’s a $445 profit (not including brokerage fees) — an 80% return on Trader A’s initial investment.
Trader B, our short seller in this scenario, could buy back his borrowed shares at $4,000, making $500. While short-selling in this case netted a slightly larger profit, on an absolute basis, it returned only 11% of Trader B’s initial risk.
Meanwhile, let’s say XYZ stock rallies to $55 within the option’s lifetime. In this situation, Trader A would be out the $555 he paid for the 50-strike put option. On the other hand, the shares Trader B borrowed at $4,500 would now cost $5,500 to buy back — a $1,000 loss.
Tips When Looking to Buy Puts
When selecting the right option to buy, traders need to consider their specific expectations for the underlying stock. Where do you think the stock is going, and how long will it take to get there? Answering these questions can help you determine the right strike price and expiration date.
Option buyers should also seek equities with low or undervalued volatility. The Schaeffer’s Volatility Index, or SVI, essentially tells us if traders are overpaying or underpaying for a stock’s front-month options, from a historical perspective. The SVI averages the implied volatility of front-month options that are at the money. Then, by using a percentile rank, we can determine if those options are seemingly cheap or expensive, from a volatility perspective. Stocks with an SVI near the bottom of their annual range offer attractively priced short-term options.
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