How to Protect Your Investments: Buying a Put Option

Should you care about buying a put option?

Imagine you put $1000 on a stock. And after a few months, it doubles its price, so you get $2000 back.

But things don’t usually go as planned. It can also drop by 50%, which means you lose $500.

And for every dollar you lose investing, it takes twice the performance only to get back to zero.

Given that all of us lose money sometimes, this problem can seriously affect your profits.

Luckily, there is a way to minimize this downside. And that’s what options trading is about.

Buying A Put Option

Buying A Put Option

Specifically, put options are contracts that allow you to sell your investments at a fixed price regardless of market prices. It means that if stock XYZ is worth $10 today and $5 tomorrow, I can still sell it for $10 tomorrow.

Of course, there’s more to it. If it were that simple, every trader would be a millionaire. But before we get into that, let’s see how this process works:

  1. You first open an options trading account. Most big exchanges will have a section for this, whether it’s forex or crypto.
  2. In the options window, you configure your Put Option and buy it
  3. With this temporary contract, you can sell your investments at the agreed price

But how do you set up the option?

  • Set the strike price: 

When do you want to execute this contract?

Suppose your stock is worth $100 today, and you believe it’s going to fall. The normal thing to do is to set this strike price at the current price, $100 if you want to execute it immediately.

You could set it below $100, but there’s no point in selling for lower than the market price.

But it might be clever to set it slightly higher, such as $120. So if there’s a spike and then falls, you now have the right to sell it at $120.

Strike prices help you capture the opportunity in volatile stocks/currencies.

  • Set the contract length:

Assuming the contract starts the moment you buy it, it can last between one day to one year.

Having more time could mean having more chances to hit your price target. But the longer you set it, the more it costs.

  • Set the quantity:

If you got unlimited quantity and a favorable price, you’d have a money-printing machine. That’s why each contract applies for a number of shares. If you want to apply it with ten times more shares, you pay ten times more.

If you’d like to apply it to more shares, most brokers will allow you to expand the contract for a price. But you need to hit the strike price again:

Say you buy a put option for 10 shares at a $100 strike price each, and the stock falls from $100 to $50. You can now buy ten shares for $50 and sell for $100. Because it’s a good deal, you want to extend it to another ten shares.

You can set the strike price at $100, but if the stock is worth $50 now, it may never reach $100 again. Your contract may expire before that happens. So you have no choice but to buy put options at a $50 strike price.

The Limitations Of Put Options

The Limitations Of Put Options

As the name suggests, options are optional. If the contract makes you lose money, you can choose not to execute it.

However, the brokers who sold you the options must accept your offer if you choose to execute it.

Imagine that you believe a stock will go up. You could buy your shares and, at the same time, buy options in case the stock falls. Which sounds like a great risk-management strategy.

Except for a few caveats:

You pay upfront

Hedging isn’t free. Not only you have to buy the option at the right time. You have to pay for that right, which we call premium. And this price may change based on the popular expectations about the stock.

The ideal put option is to set the strike price as high as possible for as many shares and as long as possible. Theoretically, this would be unprofitable.

The good news is, you can choose different trading styles:

a. Set a high strike price and short length to capitalize on market spikes

b. Set a low strike price and high quantity to profit by number

c. Set a high price and length to win by longevity

Each of these three factors has different prices. But before you find your optimal strategy, there’s another limitation you should consider

There’s a strike price limit

Brokers sell options because they profit from them. And to reduce risk, they limit how high or low you can set the strike price.

So if you’re expecting to execute a $500 strike price when the stock is worth $50, they may not let you do that:

Imagine the stock is worth $100, and you’re expecting a spike tonight. But the options ask price and bid price is $50 and $200. That’s the lowest and the highest they’re willing to trade.

So if you believe that tomorrow it will hit $500 and bounce back, the most you can agree is $200.

If it falls to $50, you can still sell it for $200. But not for $500 as you wanted.

And as market prices change, so does the allowed range.

In the case there aren’t such limits, you’ll instead find unreasonable premiums.

You earn less money

You can’t make money long-term without risk management. But that’s not free either. So when you buy that stock, remember that you need to sell it for higher than planned.

You buy XYZ for $100 and want to sell it for $120. If you spent $10 managing risk with a put option, you spent $110 in total. How much do you need to sell it? 130?

From $100 to $120, there’s a 20% increase. $110 plus 20% make $132. For $130, you lose around 2% of the profit margin.

And the more you spend on the premium, the more margin you lose.

Is it worth it?

Well, compare that to losing money. As mentioned earlier, it takes 200% to recover from a loss, because:

If you turn $100 into $50 (50% loss), you need 200% to turn $50 into $100.

Put options are perfect insurance to minimize loss, but they limit how much you can earn. In the case the market goes in your favor, the premium you paid is “wasted” money.

In the same way, insurance seems useless if nothing in your life goes wrong. The difference is that in trading, we make mistakes all the time.

Put Options: Make Money With (Almost) No Money

Make Money With Almost No Money

Put options serve to minimize risk when used along with stock trading. But you can trade options with any security, let it be commodities, ETFs, or bonds (as long as someone offers them).

And Put options aren’t the only way to optimize your strategy.

The opposite would be call options, which allow you to BUY at a strike price.

And that could make the risky stock shorting much more secure.

It’s easy to think of call and put options as opposites. The difference is in the range:

  • With put options, the best case is to see a stock fall to zero (which is super-rare). So if you buy for “$0” and sell for any price, you make infinite money

The challenge is to find someone who sells options for that stock.

  • With call options, the best case is to see the stock grow exponentially (which happens all the time). So you can buy low and multiply your money

The beauty of options is, you get the right to trade at your price, assuming you have something to trade. But you don’t have to.

Let me explain:

I pay a $20 premium for ten shares ($2 each), a put option at a $100 strike price (current stock price). If the stock falls to $50, then I can go buy ten shares for $50 and sell for $100.

When I bought the option, I didn’t own any. If I buy now, I pay $520 in total ($50+$2 ten times) and sell for $1000. $480 net.

If the stock goes up, then I only lost 20 bucks.

By spending small money, you’re revealing where to spend your big money.

But what if I don’t have $520 and can’t borrow from anyone?

Those $20 now have a higher intrinsic value, which went from $0 ($100-$100) to $50 ($100-$50).

If I wanted to buy options again, they wouldn’t cost $2 each, but at least $4. And I can sell them for that.

And if you scale up, you have a reasonably low-risk trading strategy.

Before you get excited, keep your feet on the ground. There are still hurdles such as brokerage fees, taxes, and whatnot. But now that you understand the concept, you can recognize when it’s smart to use it and when it’s not.

Put Options Aren’t Your Only Option

Put Options Arent Your Only Option

To sum up, let’s see how put options perform compared to other methods.

Suppose there’s a stock XYZ pricing at $100 per share. Because you believe prices will fall, you have two choices:

a. Short the stock and buy back when it’s low

b. Place a put option while keeping your shares

Sell Short on XYZ

  • Assume 100 shares sold short at $100
  • Margin required to be deposited (50% of total sale amount) = $5,000
  • Maximum profit—assuming XYZ falls to $0—is $100 x 100 = $10,000
  • Maximum loss = Unlimited!
  1. Scenario 1: Stock declines to $50 by December giving a potential $5,000 profit on the short position ($50 x 100 shares)
  2. Scenario 2: Stock is unchanged at $100 in December, with $0 profit or loss
  3. Scenario 3: Stock rises to $200 by December, creating a $10,000 loss ($100 x 100)

And this excludes some minor details such as:

  • Brokerage and shorting fees
  • The lender can request the loan back for liquidity reasons anytime

And when you’re out of margin, you’re out of the game:

Imagine the stock spikes and then plummets to nearly zero. Even if that spike exceeds your margin by a dollar, you’re out and won’t short the massive fall.

Buy Put Options on XYZ

  • Assume buying one put contract (representing 100 shares) expiring in December with a $100 strike and a premium of $10.
  • Margin required to be deposited = None
  • Cost of put contract = $10 x 100 = $1,000
  • Maximum theoretical profit—assuming XYZ falls to $0 is ($100 x 100) – $1,000 premium = $9,000 (or -$1000 if you bought 100 shares at $100)
  • Maximum possible loss: $11,000 ($1,000 if you trade without owning shares)
  1. Scenario 1: Stock declines to $50 by December, there is a $5,000 nominal gain in the option as it expires with $50 intrinsic value from its strike price (100 – 50), but since the option cost $1,000, the net is $4,000 (or let the contract expire)
  2. Scenario 2: Stock is unchanged, the entire $1,000 is lost
  3. Scenario 3: Stock rises to $200 by December, the loss is still capped at $1,000. But if you held 100 shares at $100, it turns $10K into $20K. $9K of profit
Share it
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments