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When there is bad news, stocks tend to go down.

Regardless of whether the bad news is company-specific, industry-wide or concerns the overall economy, stocks may start moving their way down a slippery slope that lasts anywhere from a day to several months.

With the recent economic uncertainties and corresponding market performance, brokers may have been calling their clients and suggesting they buy put options on stocks they’ve been holding for the long haul. This potentially provides a bit of protection against their stocks going down.

What are “put options?” Here are some basics:

For those who are unfamiliar with put options, here’s a basic rundown of how they work. They provide you with a way to protect your portfolio from losses during market downturns; this is known as a hedge.

For example, when I buy a put option for a stock that I own, I am essentially paying a premium to someone else so that I have the option to sell that stock at a specific, previously agreed-upon price at a given date in the future (the expiration date). When used as a hedge, put options can also be viewed as “locking in” the current price of a stock and insuring that I get paid that high price in the face of potential future losses. I am basically buying insurance on my stock.

If the stock price goes down, then the value of my put option goes up. At this point, I can choose to sell the option for a profit.

Inversely, if the stock price goes up, then the value of my put option goes down. That may be O.K., since I bought the put option as insurance for my stock against a downward move. No downward move occurred and I can sell the put option at a loss.

Let’s try an example. When Company XYZ is trading at $35, then all put option strike prices above $35 are said to be “in the money.” The $40 option is “in the money” because I will pay about a $5 premium to own the right to sell XYZ for $5 more than the price where it is currently trading, $35.



Note that the actual price of the premium I will pay takes into account the time until the option expires and the volatility of the stock, in addition to the difference between the put option’s strike price and the stock’s current price:

  • More time to expiration means you pay a higher premium.
  • Less time to expiration would result in a lower premium.
  • More volatility means you pay a higher premium.
  • Less volatility would result in a lower premium.

So, with this in mind, when I purchase a $40 put option, then I may pay a bit more than a $5 premium per share for the “in the money” put option.

Now, let’s say I’ve done some homework and I think Company XYZ’s share price will drop within the next few days. So, I call my broker or I go to my online account and I actually buy the XYZ “in the money” $40 put option while the share price is $35. To keep the example simple, let’s say I pay about a $7 premium per share for the “in-the-money” put option. This price takes into account the time to expiration premium and the volatility premium:

  • $40 Put Option Price: $40
  • Current XYZ Stock Price: $35
  • Difference: $5
  • Time Premium: $1
  • Volatility Premium: $1
  • Total Price I Pay: $7

A few days later, XYZ is trading down around $27. After consolidating around this price for a few more days, it looks like it found support around $30 and has started to show signs of climbing higher.

At this point, I can sell my put option at a profit. If the stock is priced at $30, you can sell your $40 put option for about $10, + $1 time premium, + $1 volatility premium for $12 total, giving me a $5 profit per share, and I still own the shares.

So, in this example, I bought a put option and I sold it at a future date for a profit. Even though my shares of Company XYZ have decreased in value by $5, I managed to make a $5 profit per share from buying and selling the put option. In this manner, purchasing an “in-the-money” put option in the face of a declining market allowed me to make money off the decline in my stock’s price.

Author:

David Ford, Co-Founder at TradingClearly.com http://tradingclearly.com

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