If you already understand the concept of buying calls, this article will be an easy read. One of the cool things about trading options is that you can easily take advantage when stock prices are dropping- Buying puts is one of the many ways to do that. If you do not already have a basic understanding of options, I recommend brushing up on a few of my previous articles so that you are on the right track.
BUT- If you already know your stuff, and are here to learn strictly about buying put options, this article will teach the fundamentals, and reveal how you can make (or lose) money by buying these things in three different market scenarios:
- The stock price increases above your strike price
- The stock price decreases below your strike price
- The stock price stays the same
So What is A Put Option?
To refresh your memory, a call option gives the owner of the contract the right to BUY 100 shares of stock from the seller. A put option is quite the opposite- defined below:
A put option gives the owner of the contract the right to SELL 100 shares of stock to the seller.
If you BUY a put contract, you have the RIGHT to sell 100 shares, but you do not have the obligation.
All of this text above sounds like a bunch of nonsense straight out of a textbook, but I am going to do my best to make this seem a little more clear.
If you buy a put contract for $10, with a strike price of $500, expiring in 21 days, this means that you now have a contract which allows you to sell a chosen stock for $500.
** Remember that option prices are denominated by 100, given the underlying 100 shares of stock- this means that this option price is actually $1000, not $10.
Still confused? Imagine you are a supplier, who is skeptical of market conditions and because of this you propose a deal, costing you $1000, with your buyer which locks in a sell price for 100 units of a hypothetical product for $500 per unit to be sold in a certain period of time. This means that during this period of time, if you choose to continue to sell, your buyer is obligated to buy this product from you no matter what happens. Using this analogy, let’s look at 3 scenarios which could happen in the market:
1. The stock price goes above your strike price
If you buy a put contract, the stock price going above your strike price is not the best thing that can happen. Going back to our analogy:
If you were a supplier, and you had to sell your product for $500 and the market decided to start doing very well, giving your product a new and improved value of $550, you would not be so happy. You have wasted your $1000 (remember the cost of your contract) on a deal which is worthless to you. Why would you sell this customer 100 units of this product for $500, when you can find another customer willing to buy it for $550? Options as financial instruments should be looked at the same way- further explained below:
- Your option cost you $1000
- Your option allows you to sell 100 stocks for $500- strike price
- The market stock price is $550
Key word here is allows. If you BUY a contract, you do not have to go through with it, you just have the opportunity to. You have the RIGHT to sell the stocks for $500 if you want to. So… looking at the bullets above, would you want to sell your stocks for $500, when you could just sell them at the current market price of $550? No. BUT- you will incur a loss of $1000, which again, is the price of your options contract.
*Main Point– When buying a put contract, if the stock price increases by ANY amount above your strike price, you lose money.
1. The stock price goes below your strike price
As you have likely guessed it, this is your ideal scenario. I am not going to waste time typing too much here, because the concept is simply the exact opposite of what is explained above. Obviously if you have the right to sell something for $500 and the market values this to $450, you will see some profit.
BUT- something to consider:
You have paid $1000 for this contract- so this stock price has to drop far enough below your strike price to compensate for this expense.
We are going to be doing some math here, so try to stay focused…
- You have the right to sell 100 shares of stock for $500= +$50,000 credit
- The current stock price is $450, multiplied by 100 shares= -$45,000 debit
- Your option price =-$1000
- Your max profit= 50,000-45,000-1000
- Max Profit= $4000
What if the stock price only dropped to $495?
Now, by changing the $45,000 debit above to a $49,500 one and keeping everything else the same we can calculate:
50,000-49,500-1000
= A LOSS of $500
**This reveals that the stock price not only has to go below our chosen strike price of $50, but it has to decrease by enough to compensate for the amount we paid for the option.
1. The stock price stays the same as your strike price
At first glance, with this given market scenario, it may seem that you would break even in your investment. BUT, after understanding what was explained above, you may realize that you would in fact incur a loss here.
The math is simple:
If you have a contract which allows you to sell 100 shares for $500 and the market is selling those same shares for $500, your contract has no value. In this case, you would incur a loss of $1000- the price of your contract.
**Main Point– If the stock price stays the same as your strike price, you will lose money
Summary
An important thing to note after reading this article, is that for learning purposes, I have done these calculations assuming that all of these contracts are being held until expiration. This means that these profits and losses explained above are the absolute maxes, and are not usually realized. With that being said, the main points to remember from this article are:
- If you buy a put contract and the stock price goes above your strike price by ANY amount, you LOSE money
- If you buy a put contract and the stock price goes below your strike price by an amount MORE than the price of your options contract you WIN money
- If you buy a put contract, and the stock price stays the same as your strike price you LOSE money
Giving this a second glance, we can see that you will lose money in 2 out of 3 scenarios, and the 1 scenario which you can win money has a condition. These odds, for me personally, are why I do not typically buy option contracts, but rather choose to sell them. In my next article, I will explain the concept of selling puts to reveal how these odds are more favorable.