Put Buying Introduction
Put Option Positions
Put Option Characteristics
Which Put Option Do I Purchase?
What if the Stock Price Increases?
Put Buying Example
Example - Using the CallsAndPuts.com "Buy Puts" Data

Option Strategy:            
Put Buying (Buy In-The-Money Puts)

Investor Sentiment:       
Extremely bearish, somewhat speculative

Profit Potential:             
Realize revenue if stock (and underlying put option) decreases in price during a set period of time. The put buyer has limited profit potential because a stock price can never go below zero.    

Risks:                             
If stock price stays the same or increases during the option period, the put buyer can lose initial investment.  The risk to the put buyer is limited to the amount paid for the put option premium.

Drawbacks:                    
This strategy relies on timing and judgement of downward price movement.  This investment strategy requires the price to move in a downward direction in a set time period.  There are many variables that can positively affect the stock price in a set period of time (earnings surprise, buyout or acquisition, new product announcement, etc) which are out of the control of the put buyer.  The investor must select both variables of time and downward price movement correctly or he/she loses entire option investment.

Put Buying Introduction

Put option buying is a very bearish, somewhat speculative strategy.  The investor is anticipating that the stock price (and underlying put options) will move in a downward direction at some point between the time the option is purchased and the expiration date. The put buyer is anticipating that a profit can be realized when the stock price moves down and the position can then be closed or exercised.  This is an alternative to short selling the stock.

Similar to the call buying option strategy, the advantage of buying put options versus shorting the stock is the ability to leverage your investment.  An investor can gain a much larger return on his or her investment by controlling a larger number of shares with the purchase of puts.  A downward movement in the stock price (and underlying put options) will generate greater returns on your investment than could be afforded by shorting the stock. 

There are two criteria that affect the pricing of put options.  The first variable is the time period between the purchase date and expiration date.  Generally, if the put option expiration date is further into the future, the more value the option will have and the price for the option will be higher.   The reason for this is the investor has a longer period of time available for the stock (and underlying put options) to move in an downward direction.  As time moves closer to the expiration date, the option has less time value because the stock (and underlying put options) must move in an downward direction in a shorter time slice.   Option prices do not decrease in a linear fashion: the time premium erodes faster as the option nears the expiration date. 

The second variable that affects the put option price is the movement of the underlying stock price.  If the stock price is moving in a downward direction, the put option premium may also be moving in a profitable direction.  The depends on a combination of time value and intrinsic or option value.   Because the put option is a derivative of the stock, the premium price is much smaller than the stock price.  Therefore, the downward movement of the put option premium is a greater percentage return than the increased profit potential of short selling stock. 

Put Option Positions

There are a number of terms that describe the option strike price in relation to the stock price.  We will outline three terms, but keep in mind that CallsAndPuts.com offers put buying data of options that are slightly "In-The-Money", or a higher call option strike price than the current stock price.  This data presents a set list of Dow, Tech Stocks, and Internet Stock selections and the nearest in-the-money put option available for those listed stocks at market close each day. 

In-The-Money:
This term refers to an put option strike price that is higher than the current stock price.  For example, if a put buyer purchased the May $15 strike price against a stock that is currently priced at $12.50, this would be considered an in-the-money put position.
At-The-Money:       
This describes a put option strike price and a stock price that are the same.  For example, if a put buyer purchased the May $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money put position.
Out-Of-The-Money:        
This put option position is riskier than the previously mentioned, but some investors find them tempting because they are the lowest-priced options compared to at-the-money or in-the-money put options. This term refers to a put option strike price that is lower than the current stock price.  For example, if a put buyer purchased the May $10 strike price against a stock that is currently priced at $12.50, this would be considered an out-of-the-money put position.  The put option strike price is lower than the stock price.

To hopefully clarify and avoid confusion, call option terms are the direct opposite of buy put options.  For most investors, it is easier to grasp the buy call option strategy.  That is, an in-the-money call strike price is less than the stock price.  For a put option, an in-the-money put strike price is greater than the stock price.   Some people find it easier to visualize this concept on a vertical line (up and down), with a stock price of zero on the bottom of the line and an infinite price on the top end.  If there is a stock price in the middle, the in-the-money put strike price is above the stock price and the out-of-the-money put strike price is below the stock price.  Again, for call options the opposite is true: the in-the-money call strike price is below the stock price and the out-of-the-money strike price is above the stock price.

Put Option Characteristics

There are a few put option characteristics that should be noted:

Put options are available in specific months and at specific strike prices for optionable stocks (not all NYSE, AMEX and NASDAQ stocks have options).  Options typically are available in $2.50 increments for stocks under $25. Here is an example of put options available - $5.00, $7.50, $10.00, $12.50, $15.00, $17.50, $20.00, $22.50, $25.00, $30.00 and $5 for stocks over $25. 

Option Expiration Day - Expiration day is at the market close of the third Friday of each month.  All option contracts for that particular option period are settled on the following day, Saturday.  On this date, your put option position will be closed (you can close the position anytime from the purchase date to the expiration date) or your put option will expire worthless (the put option strike price is above the stock price).

Volatility - Put premiums are based on the potential upward or downward fluctuations in the stock price.  If there is a higher possibility for the price to move up or down, the put options are generally priced higher.   Because the put buyer tries to take advantage of these larger swings in a particular stock by timing the market, there is more demand for those premiums which increases the price of the put option.  As a general rule -- the higher the volatility of the stock, the higher the option premium because there is a greater possibility that the put option will move in a profitable direction.

Which Put Option Do I Purchase? 

There are multiple options for every optionable stock.   Not every stock on the NYSE, AMEX and NASDAQ have options available.  There are thousands of optionable stocks which translates to tens of thousands of call and put options. The difficulty for the investor is deciding which put option to purchase.   Even if the investor knows which stock they want to invest in, they still have to decide which underlying put option they should purchase on that stock.  This requires them to make a determination if an in-the-money, at-the-money or out-of-the-money put option will be the most profitable for a set period of time.  The two variables the put option buyer must determine are: 1) which put option strike price to purchase on a selected stock, 2) How far into the future should the put option be purchased (option expiration date).

Typically, a put option buyer will generate profits if the stock (and underlying options) decrease in price during a set period of time.  But, if an investor purchases the incorrect put option for a particular stock at an inappropriate time, the investor can go from a significant profit to being in a losing position that they may be difficult to recover from.  Selecting the correct option at the correct time is critical in taking advantage of put buying opportunities.  The investor has to evaluate their risk versus reward criteria and then be disciplined to execute their option investment strategy.

In no way should a cheaper option price be the determinate in which put option to purchase.  Remember, the cheaper put option would be out-of-the-money (below our stock price).  The following factors must be considered when buying put options:

1. What is my time frame before I need to close my investment position and have access to my funds?
2. What is the percentage return criteria I am trying to meet?
3. What is my risk versus reward criteria?
4. Have I considered the worst case scenario and how I can recover from this in any given put buying situation.  What is my recovery strategy should the stock price go up?

The time remaining before the option expiration date is a key factor in the decision criteria.  If the stock is close to at-the-money and is nearing the expiration date, then the option premium will closely track the change in the stock price.  The CallsAndPuts.com put options data includes the first in-the-money put option for various high profile Dow, Tech, and Internet stocks.  Again, remember that buying puts (or calls) as its own strategy is very risky.  Time is working against the put option buyer as soon as the order is executed.   

What if the Stock Price Increases?

It is mandatory that the put option buyer consider his/her investment exit strategy.  The put option investor needs to decide before executing the order what the exit strategy will be if the option drops in price.  At what point will the put option position be closed to minimize losses?  Because time is such a major part of the valuation of a put option premium, an increase in the stock price adversely affects the put option premium to a much larger degree. 

Put Buying Example

Let's go through a put buying example:

Stock Company Name/Ticker Symbol:  Compaq Corporation (CPQ)
Stock Price:                                            $27.50
In-The-Money Put Option Premium:           June $30 @ $7.00
Put Option Purchase Date:                        Purchased the $30 @ $7.00 on 5/15/00 ( I have 5 weeks for the stock price to move in a negative direction)
Put Option Expiration Date:                       June (The market close of the third Friday of the month)

As you can see, I have eliminated the out-of-the-money put premium in this scenario.  The CallsAndPuts.com "Buy Puts" data only includes the in-the-money put options for selected Dow, Tech, and Internet stocks.  The reason that only in-the-money put options are included is because out-of-the-money put options tend to lose time premium rather quickly and are more risky.  When buying put options it is generally more conservative to concentrate on in-the-money puts unless the stock is going to decline dramatically in a very short time period. 

In this scenario, I am assuming that the stock price is going to make a significant downward move prior to the third Friday of June (expiration date).  As the put buyer, I am well aware that time is working against me and I need the stock price to move down in a very short window of time.  You may ask, "what makes the put buyer assume that the price will move in a negative direction?"  There are many variables and fundamentals that can be analyzed to draw this conclusion.  Possibly technical indicators (Bollinger Bands & RSI), anticipated bad earnings announcements or warnings, buyout rumors, etc., could cause the stock price to decrease which in turn may increase the value of the put option premium.  Once the increase in the put option is realized, it is almost always to the advantage of the investor to close the position and lock in profits. The conservative approach is to buy the in-the-money put option strike price ($30) for $7.00 per contract.  This is usually the case with a straight put buy option strategy, but there are some combinations, spreads, etc., that utilize put option buying to enhance and maximize profit potential.  Please view the other put option strategy descriptions and data on CallsAndPuts.com. 

Example - Using the CallsAndPuts.com "Buy Puts" Data

Now that we've explained the put buying strategy, let's use the CallsAndPuts.com "Buy Puts" data to select a put option play as an additional example: Buy Puts Example

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