Buying or Selling Puts as an Investment Strategy
Whereas Call options allow one to benefit on a stock price going up, Put options allow one to benefit when a stock price goes down. Just like a Call, you may either buy or sell a put and which you do depends on your situation and whether or not you own the underlying stock. Most of the same benefits mentioned for Calls also apply here. A Put buyer or seller receives leverage; possible income from current holdings without having to sell and protection against sudden stock movement (insurance more or less).
As noted earlier, pay attention to whether we are BUYING or SELLING a put in the following examples. They are not the same thing and both constitute a unique strategy. The first example concerns BUYING a put, while the second concerns SELLING a put
BUYING PUTS -- A put can be bought by anyone, regardless of whether or not they own the underlying stock. A put is essentially a bearish position in that one who owns a put is anticipating a decline in share price.
EXAMPLE -- INVESTOR A works in the pharmaceutical industry and is well aware of how adversely the new government policy will be to certain companies within his industry. Knowing that the vote for the legislation is to take place within two weeks, Investor A would like to profit on what he feels to be a certain downturn in the share price of the affected company. A calls his broker who recommends a Put option as the appropriate investment.
The broker searches and finds that ABC Corp (one of the primary companies which will be affected by the legislation) is currently trading at $100 per share. He further notes that there is a put option available with a strike price of $50 and an expiration date of May 25th (one week after the vote takes place). The price of the put is $4. He calls investor A and relates the information. A agrees to purchase the put option and the broker carries out his instructions. A buys 1 put option for $4, which nets out at a total cost of $400.
Subsequent to A's purchase the vote does go through and the stock price drops all the way to $35 a share. A has an intrinsic profit of $15 or $1500 ($50 - $35 x 100) on the share. His original expenses were $400 so his actual net on the transaction is $1100 ($1500 - $400).
PROTECTIVE PUTS (Covered) - A protected put is very similar to a covered call in that the investor already owns the underlying stock. The buyer of the put is buying the write to sell the shares at the agreed upon strike price on or before the expiration date. Investors seeking to protect what profit they have in a stock or those seeking to protect against downside risk are both proper motivations for a protected put. The following example illustrated this principle.
EXAMPLE -- Investor B purchased XYZ Corp. when it was at $25 per share. Since then the stock has risen to $50 per share. B still believes the stock will continue to go up but he would like to benefit from some of that profit now while at the same time protect himself should it decline rapidly. B calls his broker who recommends purchasing a put. A agrees to evaluate that option.
After checking the various options B's broker calls to inform him that there is a Sept. (3 months from now) put available with a strike price of $40, which is selling at a premium of $2. B agrees to purchase the put and thus pays $200 ($2 x 100) for an option giving him the right to sell the stock at $40 between the date of the option purchase and the date of its expiration.
Subsequently the stock price declines to far below the $40 strike price. B exercises his option and sells the stock at $40 per share. Thus he protected himself against the loss in value by paying $400 for the put option. In a sense, the price of his "insurance policy" against the stock declining was $400.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.