Mark Larson

Strategies > PUT OPTIONS

A put is an options contract which grants the owner of the put the right, not the obligation, to sell the underlying security at a specific price, within a specific time frame. The owner of a put (long the put) is expecting the underlying security to decline in price. Unlike a call option, the put option buyer does not have unlimited profit potential. This is so because theoretically, the underlying security can rise in price infinitely. Therefore, a call option can rise in price infinitely. However, an underlying security can never drop in price below zero. Therefore, the maximum profit a put option buyer can receive is if the underlying security drops to zero. I wouldn't expect this to happen.

Assume a trader expects the price of XYZ to decline from its current price of 93. He might buy the November 95 put option for 4-1/4. Should the price of XYZ decline to 88 by November expiration, the put option would be worth 7 points. A gain of 2-3/4 points or 69%. The investor might also choose to close the position if XYZ drops two or three points quickly. This is because there would still be a significant amount of time premium left (assume 3 or 4 weeks left to expiration). If this is the case, the investor would profit almost dollar for dollar with the decrease in price. Thus, he would realize even larger gains. Should the price of XYZ rise instead of decline, the most the investor can lose is his original investment of 4-1/4 points (plus commissions). The risk is predetermined and set at the time he initiates his options position.

Another important thing to consider is that the short seller of stock is obligated to pay the dividends. The put option buyer is not obligated to do this.
Many investors who own stock in their portfolio will buy puts in order to protect their portfolio in the event the stock(s) turns decline in price. Another alternative for a portfolio diversified with many S&P 100 stocks, is to purchase OEX puts. That is, a put option on an entire index which mirrors part or all of your portfolio.  For more information on using Protective Puts visit Index Options.
Buying an out of the money put option carries a greater return, however, it carries greater risk. As is the case with a call, a buyer of an out of the money put option can find he picked the direction right, however, the underlying security didn't move down fast enough, leaving him with a loss. With a few exceptions, it is too risky for me to buy an out of the money put option or call option.

If a put option buyer finds himself with a substantial profit on the put, he can take several different courses of follow up action involving different options strategies. He can sell the put option (liquidate his position) and take the profit. He can do nothing and remain in the position. He can sell (liquidate) the put option, take the profit, and roll down into another put with part of the profit. Thus, holding a put option with someone else's money. He can maintain the put option and sell an out-of-the money put option creating a bear spread with puts. Or last, he can buy a call for protection.

For example, an investor with a five point profit in a put option he's holding, may decide to sell (liquidate) the put option. He takes his profit and is on his way. However, this prevents the put holder from participating in any further gain because of further decline in the underlying security.

The investor can do nothing and hold the put option until expiration if he is up several points on the put. However, this is a risky tactic. While he may profit further if the underlying security goes down in price, he may also give substantial amounts of profit back if it rises in price.

Another options strategy alternative to the investor with a substantial profit in a put option is to sell the put and buy another lower strike put option. Assume an investor has purchased the XYZ November 95 put when XYZ was at 96 at a price of 1-1/2. A couple of weeks later, with one month until expiration, XYZ has fallen in price to 91; and the November 95 put option is now worth 6-1/2 points. The investor could sell the November 95 put option for 6-1/2 and buy the November 90 put which is presently at 2-1/2. He has now kept 4 points of profit and is participating in the November 90 puts with someone else's money. Further, he can participate in any further downside movement by XYZ.

The investor with large profits in a put option can also create a bear spread by selling the next lower put. Going back to our XYZ example, the investor holding the November 95 put, with XYZ trading at 90, may want to sell the November 85 put option for 2-1/2 points. This would cover the cost of his original transaction (the original purchase of the November 95 put), allow him to participate in further downside movement, lock in some profits, and limit his downside risk. Should the underlying security rise above 95 by expiration, both puts are worthless. However, the investor loses nothing because the put option he sold paid for the put he purchased. Should XYZ decline to 85 at expiration, the November 95 put will be worth 10, and the November 85 will be worthless, resulting in a 10 point profit (12-1/2 points overall return - 2-1/2 points originally paid for the November 95 put). See the section titled bear spreads with puts.

One other options strategy to consider after a put option increases in price and substantial unrealized profits have accumulated, is to simply purchase a call. Assume the XYZ November 95 put has increased in price from 2-1/2 to 6-1/2. XYZ has declined in price from 96 to 91. The investor could purchase the November 90 call option for 2-1/2. Total cost at this time is 5 points. No matter where XYZ is at expiration, this trade will be worth at least 5 points. Further, if XYZ is above 95, or below 90, this trade will be worth more than the 5 points paid. The investor has guaranteed that he is in a risk free position. Further, if the underlying security doesn't stabilize at 90, he may profit handsomely should the underlying security move dramatically in price.
Yikes! What happens if you bought the XYZ November 95 put when XYZ was at 96, and three days later XYZ is trading at 98? I'm embarrassed to tell you how many times this has happened to me.

If the underlying security has now assumed a bullish pattern, the wisest thing to do is probably sell the put option and take the loss.

The second options strategy alternative is to sell two XYZ November 95 puts for a hypothetical price of 1-1/2 each. The options trader would simultaneously purchase one November 100 put for a hypothetical price of 3. The net cost to the investor is the cost of the commissions. The investor has now turned his options position into a bear spread. Should XYZ decline a little in price, he will hit his break even point. Thus, he has raised his break even point. However, he has limited his profit to 2 points.

A trader using options strategies has to be prepared to use some creative and flexible strategies in his follow up action. Rarely is an options trader locked into one course of action.