Money Matters Wealth Tip #73 – Options 103: Trading Puts
Our focus for this article will be trading put options.
If you have been following along last several weeks we discussed options in the posts below.
Please go back and review the articles so that you can get a broader picture of options as this post will be focused on put options.
A put is an option that is purchased at a specific price and for a time period that gives the holder the right but not the obligation to sell a certain security at a specific price. The purchaser believes that the underlying stock will trade lower than the exercise price.
Options limit your risk
When you invest the objective is to make money. There are times when you will lose money. Using options can limit your risk. Specific to the use of put options limiting your risk is a strategy you can employ.
Here is how that would work
If you held a position in a security that you intend on holding for a long period accumulating dividends and have accumulated growth using put options can protect your gains.
For example you have a position in XYZ corp that you held for a few years the dividend is 4% and you have a 30% increase in market value. To protect yourself you may purchase a put option to protect your gain. If the stock is currently trading at $100 per share you can buy a put option expiring at some future date at $100 exercise price for a fee of $1 per share. If the price of the stock declines your option will go up in value protecting your gain.
Even though the stock price is down you have a gain in the option to offset the price decline. Therefore you have bought insurance against your gain.
Sell the option and take a gain. The stock price will recover but in the mean time you have protect much of your gain by using this strategy.
Pricing of Options
Today is March 29, 2020. I may look at options expiring in 30 days or I could look longer. The closer the option is to expiration the lower the cost. If I was to go longer I would pay a premium.
Let’s go back to XYZ Stock currently trading at $100. I believe it will be decreasing in price but am not sure when exactly. I am not comfortable with 30 days, I want to take 90 days.
When I look at options for XYZ I will look at June 20, 2020 option expiration with a strike price of $100. When I look at the pricing I see that the cost of an option is $2.00. What am I paying for, two things the right to sell the shares at $100 and the time in which to sell the shares. I have 90 days to exercise my right at $100 per share. Breaking the $2.00 down in time and the right. The cost of the time is $.75 about $.25 per month. While the right is $1.00. To breakeven I will need the shares to decrease by $2.00.
Exercise or not to exercise
If I exercise my right to sell shares at $100 I would realize $98. The $100 for the shares less the cost to of the option at $2. So to breakeven you will need the share price to go below $98.
I will tell you that I have never exercised my right to sell a stock. I always sell the option. Most times I do not even own the stock.
Two strategies
If you believe a stock price in going to decline you can purchase a put to hedge against the price decline if you own the stock.
The other strategy is to just purchase the put option and if the price declines the put option will increase in value creating a profit.
The use of put option sets you up to make money in a declining market.
A word of caution only trade with money you can afford to lose. Do not use your rent of mortgage money to trade. Every trade does not end in a profit. There will be loses along the way.
I hope this was helpful in your education. Next week we will discuss risk management.
Let me know what you think in the comments below. If you would like to know something let me know in the comments as well.
If you enjoyed this Money Matters Wealth Tip the series can be found HERE.
Other articles of interest:
10 Easy Steps to Creating a Budget that will put you on the path to Financial Independence
How to get out of Debt: Three popular Plans
4 Payoff Credit Card Debt Strategies
So what are you waiting for? Need help getting started, Grab our FREE budget tools to help you along on this very important journey.
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