An option is a contract which gives the buyer the right – but not the obligation – to buy (a “call option”) or sell (a “put option”) shares of the underlying security at a specified price (the “strike price”) on or before a given date (the “expiration day”)

Application:

If you feel a stock or the NASDAQ, NYSE, AMEX etc is going to drop then you would buy put options. When and if the stock or market drops the value of the put options increase. Often the percentage the stock drops is only a fraction compared to the percentage increase in value of the option. 10% drop I market could be a 120% increase in put option contract.

Real Estate Example:

Imagine you see a house that you believe is going to increase in value. With real estate you would have to buy the house and wait. Now imagine you like a stock that you believe will increase in value. Most people just buy the stock. However, an option gives you the ability to buy the house in the future but at the today’s price. If the house increases in value the option holder buys the house and profits from the increase in price.

Now instead of a house, suppose you find a stock you believe will decrease in value over time. You simply buy a Put Option that is good til 1, 2, 3 or more months from now. This Put Option gives you the ability to make the person who sold the option buy the stock at some time in the future when it may be worth half of what it is today. However, they pay you today’s price. Profit = the difference between today’s price and what it is worth when the put option seller is forced to buy it.

Put Options as Insurance:

The put option protects against capital loss and also allows us to take bearish positions in the market without having to sell stock short (which is riskier). Like insurance, a you pay a premium and purchase a put option to protect your holdings. If market crashes, you sell the put option at an increased value to offset any losses or exercise the option and sell the stock.

Put Options Trading Strategies:

  1. Protective Put Strategy- used to protect an existing long stock position an investor holds from a huge price drop.
  2. Selling Put Options -Put option writers, also known as sellers, sell put options with the
    hope that they expire worthless so that they can pocket the premiums. This is riskier but profitable.
  3. Covered Puts – the written put option is covered if the put option writer is also short the obligated quantity of the underlying security.
  4. Naked Puts – the short put is naked if the put option writer did not short the quantity of the underlying security when selling the put option. Writing naked puts is employed when the investor is bullish on the stock or security.
  5. Put Spreads – is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss but also limits the potential profit.
  6. Married Put – is an option strategy whereby an investor, holding a long position in stock, purchases a put on the same stock to protect against a depreciation in the stock’s price.
  7. Buy a Put- is the simplest way to trade put options. If you believe a stock will drop shortly, buy a put and profit from drop in price.

Option Characteristics

  • Call Options increase in value as the stock to goes up.
  • Put Options increase in value as the stock to goes down.
  • Option contract represents 100 shares.
  • If the option is not used (exercised) before the expiration date it becomes worthless.
  • Option holders do not have rights of stockholders – e.g., voting rights, regular cash or special dividends
  • Option’s expiration is the Saturday following the third Friday of each month.

Leverage-

An option contract provides leverage for a trader as they can control a greater amount of stock for a fraction of the cost of buying them. One thousand shares at $150 each is $150,000. But ten options contracts controls those same 1000 shares for probably a few hundred dollars. The strike price, is a fixed price that allows the option holder to buy or sell the underlying stock at a certain price. The premium is the price (cost) of the contract and changes daily due to the forces of supply and demand of the market.

Buying/trading puts is less risky than selling short (selling short is when an investor borrows stock from a broker, sells it and then buys it back at a later date to repay the broker). With put options you cannot lose more than your initial investment which allows your your downside risk.

Warning Options Trading is extremely risky and very difficult and should only be attempted after several months of studying and trading stocks. Upwards of 80% of options expire worthless. Which means people lost a lot of money.

Options can be traded just like stocks. You can buy and sell the same option all day long or you can buy options that expire this month, next month or even years into the future. Although now is the ideal time to trade put options due to the huge drops in the market one can definitely lose a ton of money in a matter of hours. Definitely spend a lot of time studying options before trying to trade them.