Guide to Buying Put Stock Options Part 2

You Believe That the Market Will
Rise Fall

Stock strategy Buy shares (long) Sell shares (short)
Option strategy (long) Buy calls Buy puts
Option strategy (short) Sell puts Sell calls

Example: Perfect Timing: You have been watching a stock over the past few months. You believe it is overpriced today, and you expect market value to decline in the near term. Originally, you had planned to buy shares, but now you think the timing is wrong. Instead, you borrow 100 shares from your brokerage firm and sell them short. A few weeks later, the stock has fallen 8 points. You close the position by buying 100 shares. Your profit is $800, less trading costs and interest.

Example: Limiting Risk Exposure: You believe that a particular stock's market value will decline, but you do not want to sell short on the shares, recognizing that the risks and costs are too high. You also do not want to sell a call. That leaves you with a third choice, buying a put. You find a put with several months until expiration, whose premium is 3. If you are right and the stock's market value falls, you could make a profit. But if you are wrong and market value remains the same or rises (or falls, but not enough to produce a profit), your maximum risk exposure is only $300.

As a put buyer, you benefit from a stock's declining market value, and at the same time you avoid the cost and risk associated with short positions. Selling stock short or selling calls exposes you to significant market risks, often for small profit potential.

The limited loss is a positive feature of put buying. However the put—like the call—exists for only a limited amount of time. To profit from the strategy, you need to see adequate downward price movement in the stock to offset time value and to exceed your initial premium cost. So as a put buyer, you trade limited risk for limited life. If you use LEAPS puts, premium costs will be higher, but you also buy more time; so for some speculators, the LEAPS put is a viable alternative to the short-term listed put.

Tip: As a put buyer, you eliminate risks associated with going short, and in exchange, you accept the time restrictions associated with option long positions.

The potential benefit to a particular strategy is only half of the equation. The other half is risk. You need to know exactly how much price movement is needed to break even and to make a profit. Given time until expiration, is it realistic to expect that much price movement? There will be greater risks if your strategy requires a six-point movement in two weeks, and relatively small risks if you need only three points of price movement over two months or, in the case of LEAPS, over many more months.