Published August 29, 2011
A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short. The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock price rises.
But when you use puts as an alternative to short stock, your risk is limited to the cost of the option contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you would with short stock. You simply allow your puts to expire worthless or sell them to close your position (if they’re still worth anything).
But be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts, you are actually increasing your risk. Options may expire worthless and you can lose your entire investment.
Puts can also be used to help protect the value of stocks you already own. These are called protective puts.
THE SET UP
• Buy a put, strike price A
• Generally, the stock price will be at or below strike A
WHO SHOULD RUN IT
• Veterans and higher
WHEN TO RUN IT
You’re bearish as a grizzly.
BREAK-EVEN AT EXPIRATION
Strike A minus the cost of the put.
THE SWEET SPOT
The stock goes right in the tank.
MAXIMUM POTENTIAL PROFIT
From the point the collar is established, potential profit is limited to strike B minus current stock price minus the net debit paid, or plus net credit received.
MAXIMUM POTENTIAL LOSS
Risk is limited to the premium paid for the put.
TradeKing MARGIN REQUIREMENT
After the trade is paid for, no additional margin is required.
AS TIME GOES BY
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.
After the strategy is established, you want implied volatility to increase. It will increase the value of the option you bought, and also reflects an increased possibility of a price swing without regard for direction (but you’ll hope the direction is down).
Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.
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