Buying Put Options on Stocks, Part 3

Example: Calling the Market Correctly: You have $600 available and you believe that the market as a whole is overpriced. You expect it to fall in the near future. So you buy two puts at 3 each. The market does fall as expected; but the underlying stock remains unchanged and the puts begin to lose their time value. At expiration, they are worth only 1.

Your perception of the market was correct: Prices fell. But put buyers cannot afford to depend on overall impressions. The strategy lost money because the underlying stock did not behave in the same way as the market in general. The problem with broad market indicators is that such indicators cannot be reliably applied to single stocks. Each stock has its own attributes and reacts differently in changing markets, as well as to its own internal changes—revenues and earnings, capitalization, competitive forces, and the economy, to name a few. Some stocks tend to follow an upward or downward price movement in the larger market, and others do not react to markets as a whole. It is important to study the attributes of the individual stock rather than assuming that overall indicators and index trends are going to apply accurately to a specific stock.

In the preceding example, it appears that the strategy was inappropriate. First, capital was invested in a high-risk strategy. Second, the entire amount was placed into puts on the same stock. By basing a decision on the overall market trend without considering the indicators for the specific company, you lost money. It is likely, too, that you did not understand the degree of price change required to produce a profit. If you do not know how much risk a strategy involves, then it is not an appropriate strategy. More study and analysis is required.

Tip: When it comes to market risk, the unasked question can lead to unexpected losses. Whatever strategy you employ, you need to first explore and understand all of the risks involved.

It is not unusual for investors to concentrate on potential gain without also considering the potential loss, especially in the options market. Options traders may lose not because their perception of the market is wrong, but because there was not enough time for their strategy to work—in other words, because they did not fully understand the stock-specific implications and option-specific timing aspects of the decision.

Once you understand the risks and are convinced that you can afford the losses that could occur, you might decide that it is appropriate to buy puts in some circumstances. Remember, though, that the evaluation has to involve not only the option—premium level, time value, and time until expiration—but also the attributes of the underlying stock.

Example: Losses You Can Afford: You are an experienced investor and you have a well-diversified investment portfolio. You own shares in companies in different market sectors and also own shares in two mutual funds, plus some real estate. You have been investing for several years, fully understand the risks in these markets, and consider yourself a long-term and conservative investor. In selecting stocks, you have always used their potential for long-term price appreciation and a history of stability in earnings as your primary selection criteria. Short-term price movement does not concern you with these longer-term aspects in mind. Outside of this portfolio, you have funds available that you use for occasional speculation. You believe the market will fall in the short-term, including the value of shares of stock that you own. You buy puts with this in mind. Your theory: Any short-term losses in your permanent portfolio will be offset by gains in your put speculation. And if you are wrong, you can afford the losses.

You are aware of the difference between long-term investment and short-term speculation in the preceding example. You have established a base in your portfolio, and you thoroughly understand how the market works. You can afford some minor losses with capital set aside purely for speculation. Buying puts is an appropriate strategy given your belief about the market, particularly since you understand that stocks in your portfolio are likely to fall along with broader market trends. Your ability to afford losses, and the proper selection of stocks on which to buy puts, add up to a greater chance of success.

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