Prices Plunging? Buy a Put!

Investors may buy put options when they are concerned that the stock market will fall. That's because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset goes down.

If you own a put, you will benefit from a down market—either as a short speculator or as an investor hedging losses against a long position.

So, whether you own a portfolio of stocks, or you simply want to bet that the market will go down, you can benefit from buying a put option.

Speculative Long Puts vs. Protective Puts

If an investor is buying a put option to speculate on a move lower in the underlying asset, the investor is bearish and wants prices to fall. On the other hand, the protective put is used to hedge an existing stock or a portfolio. When establishing a protective put, the investor wants prices to move higher, but is buying puts as a form of insurance should stocks fall instead. If the market falls, the puts increase in value and offset losses from the portfolio.

Opening a long put position involves "buying to open" a put position. Brokers use this terminology because when buying puts, the investor is either buying to open a position or to close a (short put) position. Opening a position is self-explanatory, and closing a position simply means buying back puts that you had sold to open earlier.

Practical Considerations

Besides buying puts, another common strategy used to profit from falling share prices is to sell stock short. Short sellers borrow the shares from their broker and then sell the shares. If the price falls, the stock is bought back at the lower price and returned to the broker. The profit equals the sale price minus the purchase price.

In some cases, an investor can buy puts on stocks that cannot be found for short sales. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because the broker does not have enough shares to lend to people who would like to short them.

Importantly, not all stocks have listed options and so some stocks that are not available for shorting might not have puts either. In some cases, however, puts are useful because you can profit from the downside of a "non-shortable" stock. In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put, whereas the short seller is exposed to considerable risk as the stock moves higher.

Like all options, put options have premiums whose value will increase with greater volatility. Therefore, buying a put in a choppy or fearful market can be quite expensive—the cost of the downside protection may be higher than is worthwhile. Be sure to consider your costs and benefits before engaging in any trading strategy.

An Example: Puts at Work

Let's consider stock ABC, which trades for $100 per share. Its one-month puts, which have a $95 strike price, trade for $3. An investor who thinks that the price of ABC shares are too high and due to fall within the next month can buy the puts for $3. In such a case, the investor pays $300 ($3 option quote x 100, which is known as the multiplier and represents how many shares one option contract controls) for the put.

The breakeven point of a $95-strike long put (bought for $3) at expiration is $92 per share ($95 strike price minus the $3 premium). At that price, the stock can be bought in the market at $92 and sold through the exercise of the put at $95, for a profit of $3. The $3 covers the cost of the put and the trade is a wash.

Profits grow at prices below $92. If the stock falls to $80, for example, the profit is $12 ($95 strike - $80 per share - the $3 premium paid for the put = $12). The maximum loss of $3 per contract occurs at prices of $95 or higher because, at that point, the put expires worthless.

The distinction between the payoffs for a put and a call is important to remember. When dealing with long call options, profits are limitless because a stock can go up in value forever (in theory). However, a payoff for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95 because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0.

Close vs. Exercise

Closing out a long put position on stock involves either selling the put (sell to close) or exercising it. Let us assume that you are long the ABC puts from the previous example, and the current price on the stock is $90, so the puts now trade at $5. In this case, you can sell the puts for a profit of $200 ($500-$300).

If you wished to exercise the put, you would go to the market and buy shares at $90. You would then sell (or put) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit, in this case, is also $200.

The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. This is known as the option's time value. For example, if the stock is at $90 and the ABC $95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value. In this case, it is better to sell the put rather than exercise it because the additional 50 cents in time value is lost if the contract is closed through exercise.