You can hedge your stock positions by going long with puts.
Buying puts is a simple strategy that can help protect your assets or let you profit even in a bear market. If you think the market is going to decline, buying puts might be more advantageous than either selling the stocks you own or selling stock short through your margin account.
Who needs put options?
Put buying is a strategy some investors use to hedge existing stock positions. For the cost of the premium, you can lock in a selling price, protecting yourself against any drop in asset value below the strike price until the option expires. If you exercise your option, the put writer must purchase your shares at the strike price, regardless of the stock’s current market price. But if the stock price rises, you’re still able to benefit from the increase since you can let the option expire and hold onto your shares. Your maximum loss, in that case, is limited to the amount you paid for the premium.
Speculators who forecast a bearish equity market often buy puts in order to profit from a market downturn. As the price of the underlying equity decreases, the value of the put option theoretically rises, and it can be sold at a profit. The potential loss is predetermined — and usually smaller — which makes buying puts more appealing than another bearish trading strategy, selling stock short.
Married put strategy
If you buy shares of the underlying stock at the same time that you purchase a put, the strategy is known as a married put. If you purchase a put on an equity that you’ve held for some time, the strategy is known as a protective put. Both of these strategies combine the benefits of stock ownership — dividends and a shareholder’s vote — with the downside protection that a put provides.
Holding the underlying stock generally indicates a bullish market opinion, in contrast to other long put positions. If you would like to continue owning a stock, and think it will rise in value, a married put can help protect your portfolio’s value in case the stock price drops, minimizing the risks associated with stock ownership. In the same way, a protective put locks in unrealized gains on stocks you’ve held, in case they begin to lose value.
Short a stock vs long put option
If you sell stock short, you borrow shares on margin from your brokerage firm and sell them on the stock market. If – as you hope — the stock price drops, you buy the equivalent number of shares back at a lower price, and repay your brokerage firm. The difference between the two prices is your profit from the trade. For many investors, buying puts is an attractive alternative to shorting stock.
|Shorting stock||Long a PUT|
|Shorting stock requires a margin account with
your brokerage firm. A short seller also faces the
possibility of a margin call if the stock price rises,
and could be forced to sell off other assets.
|Puts are purchased outright, usually for a much
lower amount than the margin requirement,
so you don’t have to commit as much cash to
|Shorting stock involves potentially unlimited loss
if the price of the stock begins to rise and the
shares have to be repurchased at a higher price
than they were sold.
| A long put poses much less risk to an investor
than shorting stock. The holder of a put always
faces a predetermined, limited amount of risk.
|Investors can short certain stocks, but only on an
uptick, or upward price movement. The uptick rule
is meant to prevent a rush of selling as the price of a security drops.
|Puts can be purchased regardless of a stock’s
current market price.
Calculating your return
Whenever you buy a put, your maximum loss is limited to the amount you paid for the premium. That means calculating the potential loss for a long put position is as simple as adding any fees or commissions to the premium you paid. You’ll realize this loss if the option expires unexercised or out-of-the-money.
If you anticipate experiencing a loss and sell your option before expiration, you may be able to make back some of the premium you paid and reduce your loss, though the market price of the option will be less than the premium you paid.
Hold or Sell the Option
Hedge a Stock Position
|If you purchase a put and later sell it, you can calculate return by figuring the difference between what you paid and what you received.
For example, say you purchase one XYZ put for $300, or $3 per share. A month later, the price of the underlying equity falls, placing the put in-the-money. You sell your option for $600, or $6 per share. Your return is $300, or 100% of your investment.
$600 Sale price
If the price of the stock has risen after a month, the put is out-of-the-money, and the premium drops to $200. You decide to cut your losses and sell the put.
$300 XYZ put price
|If you purchased the put to hedge a stock position, calculating your return means finding the difference between your total investment — the price of the premium added to the amount you paid for the shares — and what you would receive if you exercised your option.
For example, if you purchased 100 XYZ shares at $40 each, you invested $4,000. If you purchased one XYZ put with a strike price of $35 for $200, or $2 per share, you’ve invested $4,200 total in the transaction. If you exercise the option, you’ll receive $3,500, for a $700 loss on your $4,200 investment.
$4,200 Total investment
A $700 loss might seem big, but keep in mind that if the price of the stock falls below $35, you would face a potentially significant loss if you didn’t hold the put. By adding $200 to your investment, you’ve guaranteed a selling price of $35, no matter how low the market price drops.
Buying Put Options – How Does It Work? by Inna Rosputnia
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