In a prior article, I discussed the risks and benefits of buying call options, which give the buyer the right but not the obligation to purchase stock at a specific price before a particular date. This strategy will make money if the price of the stock goes up enough to offset the cost of the call option.
But what if you believe that a stock will go down? There are a couple of ways to take advantage of this with options. In this article, I’ll discuss the strategy that is potentially the most lucrative: buying put options.
A put option is similar to a call option. Rather than giving you the right to buy 100 shares of stock as a call option does, owning a put option give you the right to sell 100 shares of the underlying stock at a specific price (the strike price) by a particular date (the expiration date). As the price of the underlying stock goes down, the value of the put increases. You can use this to your advantage whether you own the stock or not.
Buying Puts on Stock You Do Not Own
If you don’t own the underlying stock, you can still speculate on a decline in the stock price. Buying a put is an alternative to shorting the stock. The put provides leverage, allowing you to make much more money for a relatively small investment, whereas shorting a stock does not use any leverage.
Another advantage to buying a put as compared to shorting a stock is the ability to limit losses. The most that can be lost by buying a put option is the cost of the option. In contrast, shorting a stock allows for unlimited losses.
One final consideration is that in order to short a stock, you must get approval to trade on margin with your broker. Buying a put does not require the use of margin.
Buying Puts On Stock You Own
Buying puts on a stock that you already own is similar to buying insurance. You are guarding against the price of the stock you own going down. If it does, the value of your put will go up. Conversely, if the stock price goes up, the value of the put will decline but that is limited to what you paid for the put. A put, like a call, has an expiration date at which point the “insurance” expires (i.e., becomes worthless). By utilizing this strategy, you are cutting into your profit if the stock goes up, but protecting against a drop in the stock price.
There are significant risks of losing money when buying put options and you should fully understand the risks involved. But when used properly, purchasing put options can protect you from declines in stocks that you own or help you benefit from declines in stocks you don’t.