Buying put options is a bearish strategy using leverage and is a risk-defined alternative to shorting stock. An illustration of the thought process of buying a put is given next:
- A trader is very bearish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply shorting stock.
- The trader expects the stock to move below $47.06 in the next 30 days.
Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44. For this example, the trader will buy only 1 put option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract). The graph below of this hypothetical situation is given below:
There are numerous reasons, both technical and fundamental, why a trader could feel bearish.
Options Offer Defined Risk
When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $44. Whether the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.
Options offer Leverage
The other benefit is leverage. When a stock price is below its breakeven point (in this example, $47.06) the option contract at expiration acts exactly like being short stock. To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100). Likewise, below $47.06, the options breakeven point, if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.
Remember, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500). However, the trader in this example, only paid $60 for the put option and does not need to worry about margin calls or the unlimited risk to the upside.
Options require Timing
The important part about selecting an option and option strike price, is the trader's exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $75 or $47.51, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.
Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur–more complicated then shorting stock, when all a person is doing is predicting that the stock will move in their predicted direction downward.
Put Options Profit, Loss, Breakeven
The following is the profit/loss graph at expiration for the put option in the example given on the previous page.
The breakeven point is quite easy to calculate for a put option:
- Breakeven Stock Price = Put Option Strike Price – Premium Paid
To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 – $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.
To calculate profits or losses on a put option use the following simple formula:
- Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration
For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price – $45.00 stock price at expiration). So total, the trader would have made $206 ($2.06 x 100 shares/contract).
If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money. For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price – $47.25 stock price). Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).
To summarize, in this partial loss example, the option trader bought a put option because they thought that the stock was going to fall. By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.
If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44. Likewise, if the stock moved up, irrelavent by how much it moved upward, then the option trader would still lose the $0.44 paid for the option. In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).
Again, this is where the limited risk part of option buying comes in: the stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.
Buying put options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.
Downside of Buying Put Options
Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.
Put Options need Big Moves to be Profitable
Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:
- 100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
- 1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.
If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:
- Shortseller: Gains $100 or 1.3%
- Option Holder: Loses $44 or 0.6% of total capital
If the stock moves down 5% in the following 30 days:
- Shortseller: Gains $250 or 3.3%
- Option Holder: Loses $44 or 0.6%
If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:
- Shortseller: Gains $400 or 5.3%
- Option Holder: Gains $106 or 1.4%
It's fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.
Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.
Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:
- Shortseller: Loses $250 or 3.3%
- Option Holder: Loses $44 or 0.6%
For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:
- Shortseller: Loses $1,000 or 13.3%
- Option Holder: Loses $44 or 0.6%
In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.
Moral of the story
Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:
- The direction the stock will move.
- How much the stock will move
- The time frame the stock will make its move