The best strategies for buying put options are speculative or protective in nature. This type of financial contract was originally conceived as a protective strategy for share owners. In this context, buying put options would be similar to buying an insurance policy against the decline in value of stock shares owned.
Speculative strategies provide opportunities to capitalize on price changes in the underlying asset, which may be a stock or futures contract. The strategy selected depends on the objective of the trade. Options include a highly leveraged contract providing a means to control a large amount of assets with a relatively small premium. Buying put options offers the opportunity to capture profits with limited risk. The maximum loss a put buyer can realize is the premium paid for the put.
As a protective strategy, buying put options guarantees the investor the right to sell the shares at the strike price. The strike price must be selected by the put option buyer and is typically the lowest price the share owner is willing to sell. The contract allows the stock owner to sell shares on or before the expiration date of the contract. This strategy is used by investors that have previously purchased shares and are concerned with downside market risk.
The married put strategy is used when the investor simultaneously buys shares and a protective put. This hedging approach offers the benefits of stock ownership, such as dividends and capital gains, while providing protection from a decrease in market value. The number of put contracts is equivalent to the number of shares purchased.
Opening a long put position is a bearish speculative strategy. The investor is anticipating a decline in the value of a particular security and can realize a leveraged profit. The premium paid for the option is the maximum risk. This plan is used as a substitute for short selling the stock.
The purchase of one options contract will control 100 shares of stock. The pricing and payout of these contracts are calculated with an options pricing model, the formula of which typically utilizes the Black-Sholes model with input variables including stock price, strike price, time until expiration, volatility, and interest rates. The payout will depend on the extent of the price move and other variables.
Buying put options is best initiated under low market volatility conditions. Volatility is a major factor in the pricing of options, and put options are less expensive during times of low volatility. An increase in volatility will increase the value of the put option allowing the investor to sell at a profit. Volatility trading is an options trading strategy that is technically unrelated to the extent of a price movement in the underlying asset.
Determining when to initiate a put option strategy is generally a function of fundamental or technical analysis of the underlying security. Long put option positions are typically opened when a decline in value is anticipated. Analysis methods must be used in order to select the best strategy. Other strategies that involve buying puts are complex option trades.
Complex strategies are created by opening multiple options positions. Buying a put and buying a call at the same time is known as a straddle. A straddle will capture profits on a price increase or decrease as long as the underlying asset moves beyond the break-even point.
Buying a protective put on shares held while selling a call is known as a collar. This strategy provides downside protection while offering the opportunity to profit from the sale of the call option. The investor should enter this trade only if the call strike price selected is acceptable as a sale price for the shares owned. Buying puts and selling calls without stock ownership is a synthetic short stock position. The payout is very close to the payout for short selling the stock and is a purely speculative strategy.
