If the market is highly volatile you might need to reevaluate the strategies when you pick investments. Whenever you buy or hold any long stock positions in the market, it can generate profits, and options are the best way to hold shares without investing the huge capital necessary.
It can help you own shares of expensive stocks and can protect your investments. It can be a huge relief to have the choice to sell your shares at a particular price, even when there is a decline in the market price.
Understanding a put option
A put option is a contract which gives you the right to sell the shares of a security for a particular price at a particular time. Remember, it is not an obligation but a right. It is the opposite of a call option and a bearish bet in the market. It means that the option will profit if the price of the security declines.
This put carries a strike price and it will not be transacted at the market price. Whenever you trade, it is a bet that at the time of expiration of the contract, the price of the asset will decline and will give you a chance to sell the shares at a price higher than the market value.
Example of put option
Let us take an example. Assume that you are bearish about a stock and believe that the share price will fall in a specific period of time. Keeping this mind, you purchase an option that allows you to sell shares at a specific rate by certain time. This price is known as the strike price.
Let us assume that you want to buy a put on ABC Inc. for $50 per share. On June 1, the share has gone up to $70 per share. Since you want to maintain the profits you have made, you buy a 6 month put option at a rate of $70. There will be two cases here.
Case 1: The stock takes a beating and falls to $60 per share. But you remain protected and you can exercise the option and sell your shares for $70. If you think that the stock will recover, you can choose to hold on the stock and resell the put option.
Case 2: If the shares keep soaring, you can let the option expire and enjoy the benefit of the increased value of the investment. You would lose out on the amount you invested in options but you hold the underlying stock.
Investors buy a put to protect themselves in case the stock price drops suddenly or the market drops completely. A put option can give you a chance to sell the shares and protect your investment portfolio from market movements.
How to trade?
Put options can be traded similarly as a call option. You can buy them through brokerages and they are similar to stocks. They can be traded in the same manner.
You can trade options over the counter. It will eliminate the brokerage and is party to party. A contract consists of 100 shares.
Core elements to consider when trading a put option
Taking out a put option means buying an option to sell the stock at a specific rate on a particulate date. When you want to make the trade, consider three important aspects.
Which direction do you believe the stock will move?
Deciding on a direction the stock will move will help determine the type of option you choose. When you are of the opinion that the price of stock will increase, you need to buy a call option and when you think it will decline, invest in a put option.
How low or high will the stock move from the price?
The option will be of value only when the stock price closes to the expiration period “in the money”. It means that the stock price should be lower than the strike price. You cannot just choose any random strike price. There is an available range of strike prices under option chains.
What you pay for the option has two elements- time value and intrinsic value. The intrinsic value reflects the difference between the share price and strike price. Time value factors volatility of the stock is and the time to expiration.
When will the stock move?
Put options have an expiration date which show the last day to exercise the option. The dates can range anywhere from days to weeks, months and even years.
You should avoid daily and risky options because they carry high risk and are ideal for professional option traders. If you are investing for the long term, monthly and yearly expiration dates are most preferred.