The Put-buying Stock Owner:

As previously mentioned, a long Put strategy can be either speculative or conservative depending on who is using it and why.

For example, an investor, who brought 200 shares of XYZ at $45 nine months ago, currently finds XYZ trading at $60! While happy with the results, the investor is concerned that XYZ might suffer a pull-back over the next several months. To protect some of the gains, the long-term stock investor can buy two Put options for protection.

2 Oct 60 Puts @ 3 3/4 = $750

Clearly, in this case, purchasing 2 Put options is not “speculating.” A $750 investment decision is being made to use options as a form of insurance on assets currently valued at $12000.

200 Shares XYZ @ $45 = $9000
Unrealized profit = $3000
For a total of $12 000

Prior to the availability of exchange-listed Puts, most investors fearing a correction in XYZ had only two choices:

• sell their shares, thereby removing both the risk of a decline as well as the benefit of any further advance, or
  
• hold onto their position in the hope that any forecasted correction in XYZ will be both mild and short-lived.
  
  If the investor is truly bearish on XYZ, he or she would be wise to simply sell the stock! For those who believe that XYZ will recover from any correction but yet want some protection in case they are wrong, Put options offer a third alternative. Purchase of a Put option is like an insurance policy guaranteeing a minimum selling price.

Note: Puts offer the investor a guaranteed minimum selling price up until the option expires. After that, the insurance policy is no longer in effect.

Now, no matter how far XYZ declines, the investor has locked in a guaranteed price of at least $56 1/4 for the next 3 months until October expiration.

By definition, a Put option gives the owner the right to sell XYZ at the strike price up until expiration. Therefore, by purchasing Put options, the stock owner is able to:

• retain stock ownership for further upside potential and ant dividends,
  
• establish a guaranteed minimum selling price by having the right to sell XYZ at the Put’s strike price, and
  
• insure that most of the asset’s current value is protected.
  
  Puts can be purchased as an insurance policy for shares that have been held weeks, months, or even years. Or, Puts can be used to limit the risk of stock ownership by simultaneously buying the Put at the same time as the stock. This is a hedging strategy known as a “Married Put” and it is covered in the description of the strategy named “Buy Stock/Buy Put” or “Synthetic Long Call” in strategy group “Bullish Strategies”.

Irrespective of its timing, the purchase of a Put, while owning shares in XYZ, is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit.

With a protective Put, the stock owner controls both when the stock is sold and at what price.

If, at expiration, XYZ is above the strike price, the Put will expire worthless. At that time, the investor can sell the stock outright or continue to hold it.

Or, if XYZ declines below the Put’s strike price, the Put can be either sold (realizing a profit or recouping some of its cost) or exercised, thereby relinquishing ownership of the stock.

No other option strategy offers as much leveraged downside potential in a falling market with limited risk to the investor’s capital. The total amount at the risk is always the premium paid for the options!

As with Call buying, stock selection, timing and strike price selection are critical to the success of this strategy.

Put buyers can be classified into two distinct categories. On the one hand, there is the Put-buying speculator, looking for the leverage options have to offer.

On the other, there is the stock owner seeking a certain amount of protection in case XYZ declines. This investor buys 1 Put for each 100 shares of XYZ owned no matter which strike price is selected.

Trade-offs:

A Review:

• The selection process is full of choices. With four different expiration months and three, four, five or more different strike prices for each month, the investor is confronted with a long list of possible Put options to buy.
  
• Not only is Put buying a strategy in and of itself, but it is also a building block used in constructing more complex strategies!

• As a starting point, the investor should ask “When do I anticipate the decline in XYZ to take place and how large will it be?”
  
• Match expectations with strikes and expiration months! Remember, when buying Puts, running out of time can be costly! The speculator’s Put options may expire before a down move begins. Or, the “insurance” Put buyer may have the policy expire right before it is needed.

• For the speculator, successful Put buying is not easy! First, the opinion must be correct. Second, the strategy often fails because the Puts expire before the stock drops to a level that produces a profit.
  
• When buying Puts for protection, the stock owner must decide if he or she wants to spend more money for more protection (an ITM Put) or pay less money for a low-cost policy with a larger deductible (an OTM Put).

• The effects of dividends notwithstanding, at-the-money Calls will have prices greater than at-the-money Puts.
  
• OTM and ATM Puts decay slower than OTM and ATM Calls.
  
• As the option becomes more and more in-the-money, ITM Puts lose their time value faster than ITM Calls.
  
• Once the Put is in-the-money, the time value portion of the ITM Put will decrease for all expiration months. This means that a Put buyer can buy a longer-term ITM Put for nearly the same price as the near-term ITM Put. Thus, for a little extra money, the Put buyer can gain some valuable time!

As a Put option becomes more in-the-money, it does not maintain the same amount of time value as an equally in-the-money Call option. For example, with XYZ at $60, the 55 Calls and the 65 Puts are both $5 in-the-money. However, as the following example illustrates, the ITM Call option for a particular expiration month is greater than the ITM Put.* In addition, this differential is not constant. The more time until the options’ expiration, the greater the difference between the Call option’s premium and the Put option’s premium.*

*Note: In this example, XYZ’s annual cash dividends are zero. As XYZ’s dividends increases or market interest rates rise, the differential between the ITM Call and the ITM Put in this example will narrow.

• Remember, experience is the best teacher. Thus, start small and, as a rule, buy some extra time!

(+) Less $’s at risk. Most profitable if big decline occurs before expiration.

(-) Larger % losses on near-term Put options if XYZ remains unchanged due to more rapid time decay.

Pros & Cons: Longer-term options

(+) More time for decline to occur and to recover from any unexpected rallies in XYZ that might occur along the way.

(-) More $’s at risk if XYZ has a significant advance.

The Put-buying Speculator:

• OTM Puts offer larger potential returns (%). But, they involve more risk. In order to reach its break-even point, an OTM Put option requires a larger decline in XYZ than either an ATM or ITM Put option. Thus, buying OTM Puts is a much more bearish position.
  
• Buying more of the OTM Puts because they are cheaper than ATM or ITM Puts is a dangerous way to trade options.


The Put-buying Stock Owner:

A stock Owner views OTM, ATM and ITM Put options as different types of insurance policies. An OTM Put is viewed as a cheap policy with a large deductible. (The protection doesn’t start until XYZ declines to the option’s strike price.) An ITM Put costs more, but has a smaller deductible. And, an ATM Put option is in between the two.

The stock investor who is concerned that XYZ may drop in price over the next couple of months can purchase a Put option for protection. The cost of this protection depends on how much of the forecasted decline from current levels ($60) the stock owner is willing to absorb.

Thus, Put options are to the stock owner what car insurance is to the car owner. They both are financial instruments used to protect the value of the individual’s asset. And, they both have a cost structure that is influenced by the amount of the risk that the individual is willing to absorb (i.e., the amount of the deductible).

The larger the deductible, the lower the cost of the policy and vice versa. In the case of the stock investor, the deductible is equal to the current price of XYZ minus the break-even point of the insurance policy (Put).

The deductible is simply the amount that XYZ must decline before the option’s break-even point is reached.

Before expiration, the break-even point is higher.

Profits are unlimited as long as the underlying stock continues to decline.

Losses are limited to the premium paid for the option.

At expiration, for every point XYZ is below the strike price, the Put option increases an additional point in value.

Time Decay: Negative.

A Put option’s premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Put erodes (i.e., decays). At expiration, the Put’s value will equal its intrinsic value.

Note: The rate of decay accelerates as the option’s expiration date nears.

Volatility:
If increases – Positive;
If decreases – Negative.

Changes in the option’s implied volatility has an effect on the “time value” portion of an option’s premium.

Thus, a change in the option’s implied volatility has the same effect as changing the number of days remaining until the option’s expiration.

Equivalent synthetic position:

This strategy: Long 1 Oct 60 Put
is equivalent to Short 100 Shares of stock + Long 1 Oct 60 Call.