This is the opposite side of the spectrum compared to call options, and
I find them to be a little more counterintuitive than call options, but once you have it figured out, you’ll find they are simple to use.
(If you've just begun this journey, start here)
Quick overview
As you probably remember, Option buyers have rights.
The same goes for buying a put option.
Buying a put give you the right (but not the obligation) to sell someone 100 Shares of stock, at a certain price, by a certain date.
Now that you're more familiar with the option lingo I think I can say it this way…
Put buyers have the right to sell 100 shares of stock, at the specified strike price, before the expiration date.
I think it's pretty cool that you know what all those terms mean. A few weeks ago you may not have had any idea what any of that would have meant. You're learning the 'Option language', and I think that's just awesome!
(if you're still rusty click here, you'll get it in no time).
Let's take a look at what we're covering today:
Our main topic is the exciting world of Put options.
1. Quick call option buying review.
a. Comparing calls to puts
2. All about buying Put options.
a. How they are most commonly used.
b. How put options actually work in the market
c. How ITM, ATM, and OTM works for Put options.
3. Bringing back our pal Frank in an example!
a. Then we'll learn how to Calculate his return.
b. Franks 3 Decisions (and the best one to make)
4. Using puts as insurance. Wait, you can do that?
a. I go over an example of how this could work for you.
b. Then we calculate your return
c. Then we go over which is the best decision and why.
5. Homework!
Call Option Review
As you probably remember, call option buyers had the right to buy shares of underlying stock at a certain strike price, by the expiration date.
Call option buying is a bullish type trade, meaning I would buy a call with the expectation of the stock to move upwards in price, before my expiration date.
The risk reward profile for a call option is:
Unlimited upside potential (theoretically anyway…)
Limited downside risk (limited to the cost of the option)
Time works against you. (option loses value as expiration nears)
For example:
Let’s say I Buy a call on a company I really like. The stock moves up in price well above my strike price and I decide to exercise the call.
For every contract I own I would be delivered 100 shares of stock (from the call seller). Even though the stock is more expensive than my call strike price, I would only have to pay the strike price for each share bought. I could then turn around and sell the shares at the market price, taking advantage of the difference in what I paid, to the stock price.
Put options are fundamentally the same, with a few key differences that we'll go over below.
Because you already learned about call options, learning how buying put options works will come a lot easier to you.
(if you haven't learned about buying calls, I recommend starting there).
Alright, let's dive in.
Put option Overview
So here we are, in Put option land (yaay).
We'll focus on the buying side of put options today to keep things moving in the same direction…
As I mentioned above, buying a put option gives the buyer the right, but not the obligation, to sell 100 shares of the company, at a certain strike price, by a certain expiration date and cost the buyer a premium to do so.
Put option sellers, on the other hand, are obligated to buy the stock, at the strike price, on or before expiration, and receive a premium.
Put options are the exact opposite of a call option.
If you buy a call you have the right to own shares at the strike price.
But, if you buy a put you have the right to sell shares at the strike price.
Selling a put is actually quite similar to buying a call.
The seller of the put is obligated to purchase the stock, at the chosen strike price, if the option is ITM (In The Money).
QQQ (Quick Quiz Question)
So, which direction do put buyers want the underlying stock to go?
Well, put option buyers are again, hoping for the opposite to that of call option buyers…
For buying a call option, your sentiment should be that your bullish the stock (you expect to see a rise in the underlying stock price).
The opposite is true for a put.
When you buy a put you have a Bearish sentiment, meaning you expect the stock to move down in price. (QQQ answer)
In fact, with put buying, that's how you become profitable, when the underlying stock moves below your strike price.
How do puts work exactly?
If the shares were exercised the option seller would be 'Put' the 100 shares of the stock from you, at whatever strike price was agreed upon.
Now why would this be good for you?
Well, this is good for you because you get to buy the 100 shares at the current market price, but the seller of the option has to buy them from you at the strike price. Make sense?
Why would you want to do that?
Well the main reason to exercise the option would be if the Put option were ITM.
If the option owner exercised their right to sell, they would get to sell those shares to the option sellers.
And they get to sell them at the strike price.
Therefore, the option buyer gets to buy the shares at the market price, and then turn around and sell them at the strike price. This Allows the put option buyer to collect the difference between the two (the market price and the strike price), as long as the market price is lower than the strike price the buyer will collect the difference.
Put Option Example
Let's bring back our oldest, and best pal Frank to demonstrate how buying a put can work. I'll also discuss how ITM, ATM, and OTM works when using a put option.
(Frank was first introduced here)
Frank has been studying and reading all he can on the ABC company. He's been reading all the quarterly reports, and has run a valuation on the company and thinks it's quite overvalued.
He also sees a near term catalyst that will likely cause the stock to move lower in price in the near future. Earnings are coming out in a couple months and Frank thinks they will come in lower than the analysts expect.
Instead of Shorting the stock, Frank decides to buy a put option.
Buying a Put will allow him to make some money if this stock does indeed drop to where he thinks it will.
ABC is currently trading at $50.
Frank thinks it's overpriced and is really worth around $40.
So Frank decides to buy One Put option.
He decides to buy a put with a strike price of $48
The cost of this put option is $1.50.
Frank picks the expiration of 4 months from now.
QQQ
Did Frank buy an ITM, ATM, or OTM put option?
Scenario #1
OK, lets say ABC stock falls after earnings to a price of $44 a share.
So first QQQ #1, is Franks option now ITM, ATM, or OTM?
QQQ #2, what choice does Frank now have to make and which do you think is best?
let’s tackle the question of profitability first, since I asked you if Franks original purchase of the Put option was ITM, ATM, or OTM as well.
Remember; For a any option to become ITM it has to have at least some intrinsic value.
(if you missed the post on Intrinsic Value or need a refresher check back here).
Basically, Intrinsic value means that if Frank were to exercise his option right now, would he make any money?
Therefore; as soon as the Stock price drops Below the option Strike Price, the Put option is ITM and therefore has Intrinsic value.
Quick Reminder:
Call option is ITM when Stock Price is above Strike Price.
Put option is ITM when the Stock Price drops below the Strike Price.
The characteristic that remains the same for both is the requirement of Intrinsic Value, or said differently, the requirement of profitability if/when exercised.
So to answer our QQQ #1, all we have to do as ask ourselves this;
'If we exercised this option right now, would we make any money, lose money, or breakeven?'
Well, let's find out…
Remember, if we exercise a bought Put option, we have the right to sell 100 shares at the strike price to the option seller, and we get to pay the current market price to buy those shares.
So,
Put option strike is $48
ABC stock is trading at $44
We buy the 100 shares at $44 dollars and turn around and sell them at $48 dollars making us a total return of $4 per share.
So the QQQ #1 Answer is… the option contract is ITM. Because it makes us money. Simple as that.
Note: this means that when the stock was trading at $50, and Frank bought the $48 Strike, his Put Option was OTM. Because, if he were to exercise his option at that time, he would receive -$2 per share (buys the shares at current market price, sells them at the strike price).
Got it!?
Sweet.
So, just to summarize…
If the bought Put Option has a strike of $40
If the stock is trading below $40 the option is ITM (In the Money).
If the stock is trading above $40, the option is OTM (Out of the Money).
If the stock is trading right at $40, the option is ATM (At the Money).
QQQ #2
So now what choice must Frank make, now that ABC is trading at $44, and his option Is ITM?
Well, there are quite a few possibilities here… Frank's Option still has 2 months until expiration, and is now ITM so he will make money right now if he does one of two things. Can you think of the two choices that will make him money right now? (remember that as a buyer, Frank has the Right to sell)…
Franks three choices
I know I said Frank had a few choices to make now, and he does, but there are really only three things he can do right now.
1. He can exercise his right to sell
2. He can sell his put
3. He can do nothing (hold it longer).
Choice #1:
Frank decides to exercise his right on the Put Option, so he buys 100 shares at $44 and sells it at $48 giving him that total return of $4 per share. Again, Frank bought One Put option, and it cost him $1.50 per share.
To find Franks net return we have to subtract his cost from his total return.
$4 - $1.50 = $2.50 per share
Not bad Frank!
Remember, each option contract controls 100 shares of stock. Frank bought One contract so we have to multiply his cost and return by 100.
So, Frank's’ upfront cost was $150, his total return was $400, this means his net return, after costs is $250 dollars.
Said another way, Frank just made $250 dollars, while only risking $150.
That means he made 166% return.
You can see why people can be attracted to this type of trading.
Choice #2:
Frank Decides he's happy with how far ABC stock has fallen and wants to get his return while it's still available.
Frank also see's that he still has almost 2 months left until his option expires. He wants to be paid for the potential that the stock could drop further on that time frame. How can he do this?
Remember an option contract pricing is made up of two types of value:
1. Intrinsic
2. Extrinsic
We know that Frank's option right now has $4.00 of Intrinsic value, but what about extrinsic value?
Well Extrinsic value can be thought of as Time Value. So technically, the more time left until expiration, the more extrinsic value there is. Therefore, as the option moves towards expiration, the time value shrinks until expiration day is reached. Once the expiration date is reached there is 0 extrinsic/time value remaining.
Frank knows this because he's been reading my blog! (smart guy) so instead of exercising his option, he decides to sell it back to the market so he can take advantage of the remaining Time Value that’s left in the option.
Frank checks the price of the option currently and sees its worth $4.50.
He sells it at that price and is much happier for it!
What's Frank's Return on Choice #2?
Well his cost is $1.50, he made $4.50
$4.50 - $1.50 = $3.00 is Frank's Net return.
Good job Frank.
So again, He risked $150, and made $300 after subtracting costs. This means that his return on investment would be…
200% return.
He increased his return 33%. He did this simply by understanding his 'options' and knowing which one would give him the greatest result.
Franks speculative decision
Choice #3:
Frank's third choice is that for now, he does nothing. He keeps his put option. He still has two months left to expiration after all…
But why would he do this?
Well Frank is feeling greedy (uh oh), he thinks the stock still has more room to fall since it hasn't hit his price target of $40 a share, so he holds on. Hoping and praying for the stock to hit his target.
But, ABC stock doesn't drop, instead it begins to rise again. It hits $45, Frank still has a month until expiration, so he holds. It continues to rise, it's now at $47. Frank has two weeks until expiration, the extrinsic value in his option is almost all gone now, but he KNOWS it has to drop again, right?
He holds it right up until expiration, the stock price now at $48.50. It's expiration Friday, what should Frank do?
Well, let's go through the choices left to him.
He could sell the option:
Well, it's the expiration day so there is no more extrinsic value. What about Intrinsic value?
Nope, His strike price was $48, the stock is trading at $48.50.
$48 - $48.50 = -$0.5 No intrinsic value here.
Sorry Frank, not this time buddy.
Moral of the story?
Don't be greedy, it almost never pays off.
No one ever went broke from taking profits early.
He could exercise the option?
Yes, but he'd lose that extra $0.50 if he does. The only time it really makes sense to exercise a put option, is when it's ITM. As soon as ABC when above Franks strike price it was OTM.
Franks return for choice #3
Well Frank's Put Option cost him $150, and that was his maximum risk.
So he lost his $150, or 100% of his trade.
Put buying Option Profile
Buying Puts has:
Limited downside risk
· Limited to the cost of the option.
High upside potential
· Upside is Theoretically unlimited (until the stock hits zero anyway).
Time value is against you (meaning the option price decreases as it get's closer to expiration.)
Casino
Because of the large potential gain that buying put options offer, people are often willing to spend money and take a chance (gamble) on the potential of a large payoff (sometimes without doing any homework on the stock at all).
Most of the time, people will be using these types of options like at a casino, throwing a little money down on #7 on the roulette table, knowing that their downside is limited to the size of their bet, and hoping to hit the big payout.
But those little bets add up to A LOT over time, and soon the option buyer has a sour taste in their mouths and gets turned off from ever using options.
This is where it (literally) pays to be on the other side of the bet. You can be the casino and collect the premium the others pay to play.
I think that will be a topic for next time.
Remember!
If you're an option buyer you don't only have to be right.
You have to be Right, right now! Otherwise your time will run out and your option will expire worthless.
Using puts as insurance. Wait, you can do that?
I was just going over this in my head, and realized it's a bit more advanced/complicated than I want to be teaching you right now. I'll do a full post on it another time, but for now I'll go over the basics of how it can be used to limit the downside risk of a stock you already own.
What can a put do for you?
Well, it can limit your downside risk while retaining your upside potential in a stock.
How you say?
Well remember, a put option price increases as the stock price goes down, so as long as you control the right number of put options (matching, your loss can be limited to the price of the Put option.
This is why people call it Insurance.
You pay an upfront premium to have that downside protection, just in case something bad happens and the stock you own crashes.
Get it?
The Upside
You get to hold onto the stock you love without worrying about being wiped out in the event of a crash.
You also still retain the possibility of the stock going higher, increasing your potential return.
The Downside
Just like with car insurance, you have to pay the premium to be protected, and it can add up over time.
The cost of the put lowers your current return on your stock by the cost of the put option.
Example:
If you own 100 shares of stock and it's increased in price to $40, you buy a put that costs $1.00, you can consider dropping your stock price by $1.00.
Why?
Because, in order for you to make up the cost of the option, you would need the stock to increase in value to $41 to make up for the cost of the option.
This Put option will only protect you for a certain amount of time. Just like with your car insurance, if you want continual protection, you have to keep renewing your insurance. In this case you'd have to keep your Put option with a technique called rolling it over, (basically just buying a Put with a further out time frame while simultaneously closing your old Put Option. I know, we're kinda in the thick of it.)
Let's go over an example so you can see how it could work in action.
Scenario
You own 100 shares of your favourite company, the XYZ company. You Bought in at $50. The stock has already made you a good chunk of change and you still really love the company.
The stock has appreciated in value to the current price of $75 a share. Nice!
You notice that the market has been pretty flat lately, and there are a lot of potential catalysts to put the market into a nosedive, but you still love the company you own, and based on your analysis, it's still not overpriced.
So, you decide to spend a little money to protect against the downside risk.
You Buy a single Put with a strike price of $75 dollars, for a premium of $3, and expiration of 3 months from now.
Why only one put?
Well in this scenario you own 100 shares, so you want to match that with your Put option so that your position is completely protected.
Ie.
If you owned 200 shares, you'd want to buy two puts to be completely protected. 5 puts for 500 shares etc.
Remember, each Put represents 100 shares of the underlying stock, and you want to get as close as you can to your actual share count to be fully protected.
In this case, you have a perfect one to one protection.
If you were to buy another put, you'd actually make money if the stock were to fall, but you'd also increase your up front cost.
So you can now breathe easy, you're protected, but you still watch the market to see what happens.
What Happens
The stock stays flat for about a month, then some bad news comes in from Germany about the largest bank going bankrupt. This causes some ripples in the market which eventually turn into waves, causing the overall market to drop by 20%.
Your beloved XYZ gets pulled down with it and it lands at around $52 a share. You breath a sigh of relief knowing that you own that put and will only lose the cost of that insurance cost.
Now you have two choices…
The stock you own just dropped $23 to $52 a share.
You can:
1. Exercise your Put option or
2. you can sell it back to the market and keep your shares.
Choice #1
You're not sure about the near term market future, and so you just want out of the market. You decide to exercise your right to sell 100 shares at your strike price. So you sell your 100 shares, collect your money and are happy you bought that insurance.
Here's how this would go down:
Since you bought that put option with a strike of $75, you can sell your shares at that price as long as the option hasn't expired. In this case you have 2 months left, so plenty of time. The stock has dropped to $52, but you get to sell your shares at the strike price of $75, so you exercise your right to do so and collect your $75 a share or $7500 and do a happy dance for buying the Put Option when you did.
Now let's look at your Net gain since you bought in at $50.
$25 increase in stock price = $2500 gain (25 x 100 shares).
Subtract your cost of the option $3
$25 - $3 = $22.00
Multiply that by your share count of 100
$22 x 100 = $2,200.00 net gain.
Nicely done!
Choice #2
You are still in love with the XYZ company and it just got a lot cheaper. Remember you thought it still wasn't overpriced at $75 a share, now it's at $52.
So, instead of selling your shares, you decide to sell the put option instead and hold on to those, now much less expensive, shares.
You originally bought the put option at $75 to match the stock option price of $75. Was your option ITM, ATM, or OTM at that time??
That’s right, it was at the money.
Now the stock has dropped from $75 all the way down to $52, but your Put Option still has a strike price of $75.
Now is your Put ITM, ATM, or OTM?
Not only is your Put In the Money, it's Deep In the Money. Remember once it's ITM we can calculate it's intrinsic value to see what the option is (mostly) worth.
Try to calculate it on your own first, then we'll dive in.
It's ok, I'll wait…
Oh you're done already!? Okie then.
As you may recall from the previous post on calculating intrinsic value, it's very simple once you know and understand the numbers you’re working with.
In this case:
Strike = $75
Current stock price = $52
Intrinsic value = difference between the two (as long as it's in the money)
$75 - $52 = $23.00
So our Intrinsic value is $23.
Now the other side of Option Value is Extrinsic value which we called time value, to keep it simple (though it has more components then only time).
You still have about two months left in your contract so we'll say you have $1.50 of value there.
Add that to the intrinsic value of $23
$23 + $1.50 = $24.50
And since you bought one contract you multiply that by 100.
$24.50 x 100 = $2,450.00 is our total return
Remember you had to pay a premium for that option, so you should subtract that here as well…
$24.50 - $3 = $21.5
$21.5 x 100 = $2,150.00
So your net return on this put option is $2,150. that seems pretty good right?
Well lets not forget that you decided to keep your shares, and they have substantially decreased in value.
Stock decrease from value of $7,500 to $5,200.
Or a loss of $2,300.
But you bought the 'Put insurance Plan'
Therefore, you can now offset that loss by your Put option gain
$2,300 - $2,150 = $150.00
If you understand Options properly you'll make more money.
But wait a minute, you might be saying…
Isn't Choice #2 the best decision, even if we don't want to own the shares?
Well let’s compare.
We already did our return for Choice #1 which was $2,200.
But what about Choice #2?
Well, we know our option return was $2,150
But, the shares are still trading at $52, and we bought in at $50 so there's still $200 in return left there.
Add that to our option return of $2,150
$2,150 + $200 = $2,350.00
Choice #1 = $2,200
Choice #2 = $2,350
You can see by just understanding options a little better, you would have absolutely gone with choice #2. That’s an extra #$150 in your pocket. Pretty sweet.
What this means.
Due to the fact that we would have made more money on option #2, even if we didn't want to own the shares, it was absolutely the best choice.
Note:
If there is any extrinsic value in the option at all, it is almost always going to make more sense to sell that option back to the market, otherwise you're just going to be leaving money on the table. And we want to squeeze as much return out of these options as possible.
Put Option as insurance Conclusion
In the end, buying that put options covered your behind, and only cost you $150 to do so. But, that's about as 'Best case scenario' as it gets. You can see, however, that if used properly (and timed properly), a put option can really do a good job as insurance on stocks you already own.
Summary
Well that was fun!! It was right?! I really enjoy checking out potential returns this way. You can run hypothetical situations like this on any stock or option. Remember to always have the downside risk in your mind, that's what's most important: Limited downside risk, high upside potential.
In the Put Insurance situation, we protected ourselves against the downside risk by buying a put. This is a much less speculative way of Buying Put Options. If you're just buying a Put Option, hoping the underlying stock will decrease, without any other research, that's gambling my friend. And that's fine, as long as you understand that you'll likely lose the money you use.
Anyway here's what we covered today and it was A LOT:
We reviewed call options and went over their risk reward profile and how they work.
Next we discussed the main topic of the post; Put Options.
1. We talked about the direction you need to underlying stock to move in order for you to become profitable (down).
2. Then we went over an example with our old pal Frank and what the characteristics Frank used before buying a put on the company.
a. He had done his homework
b. He understood the value of the company
c. He strongly believed it was overvalued
d. And most importantly, he saw a near term catalyst that would likely drive the stock price down.
3. We next reviewed ITM, ATM and OTM with some QQQ’s mixed in.
4. Then we went over the decision making process after the Option became profitable
5. We reviewed the Put option risk reward profile.
6. We talked about a Casino and how it related to buying options.
7. Then we dove deep into some fun stuff; Using Put Options as Insurance. And we really went into it. We discussed the pros and cons and went over an example to demonstrate how the trade could play out. We also discussed the and how you could better utilize selling the option instead of exercising the option for a more profitable trade.
Homework!
Here's the fun part, the actual practice.
Today I want you to look at any one holding you currently own (or want to own) and ask if you'd ever want to use a put as insurance to cover that asset.
Next I want you to find a company you think is overvalued, and think buying a put option might be a good idea to make money as it falls (remember to look for near term catalysts that may cause it to drop).
Next, and most importantly,
Email me your ideas and I'll go over them with you!
I hope you enjoyed this post, it was a big fella. Thanks again for making the commitment to read it all the way through. Seriously, good job.
We'll talk soon.
~Ryan Chudyk~
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