Why — and how — to buy put options?
You’d buy a put option if you expect the price of an underlying security to fall. When you buy put options, you’re betting that, at the time your contract expires, the price of an underlying stock will go down. This gives you the opportunity to sell shares of that security at a price higher than the market value, which earns you a profit. You limit your risk of loss by paying a premium to the seller of the put.
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How to Buy Put Options
Traders buy a put option to increase profit from a stock’s decline. One option is referred to as a contract, and it represents 100 shares of the underlying stock. Read on to learn how to buy put options.
Put options can be bought through brokerages like TradeStation, TD Ameritrade, Robinhood and more. Since options are financial instruments similar to bonds or stocks, they can be traded in the same manner. However, the process of buying put options is quite different, since they are a contract on underlying securities, rather than buying the securities outright.
Zero trading commissions are just the tip of the iceberg when choosing an options brokerage. Consider other hidden fees, including data fees and platform fees. Different traders have different trading strategies, needs and skill levels.
You may want to identify a platform that has plenty of guidance and educational resources if you’re a rookie trader. On the other hand, look for pro-grade features and research if you’re a seasoned trader. Here are some of our favorite online stock brokers to get you started.
Choose Strike Price
The strike price of a put option is the price at which you can sell your underlying securities. With a put option, the buyer has a right to sell 100 shares of stock at the strike price — before expiration. Choosing the strike price is 1 of 2 crucial decisions you need to make. The other is the expiration date.
In practice, there are standard strike prices for securities with the active options market. The most-often traded options have strike prices in $5 increments — $15, $20, $25, etc.
There are a few important concepts to know when you choose a strike price:
- In the money: If your put option expires in the money, it means the strike price is above the current stock price. The option holder can purchase shares from the market and exercise the option to sell the shares at a higher price.
- At the money: This concept indicates that the strike price and current stock price are the same.
- Out of the money: If a put option expires out of the money, the set strike price is below the stock price. The option holder can’t exercise the option and make a profit. However, this doesn’t make an out-of-the-money option entirely worthless. Stock prices are dynamic, so an out-of-the-money could easily turn into an in-the-money option as prices change.
You could also take advantage of the fact that out-of-the-money options aren’t typically exercised and sell them to anyone looking to bet on the movement of a security. This way, you may earn some income by collecting the premium paid for those options.
Choose Expiration Date
Your trading style should guide your choice of expiration date. It sets the timeframe for when you can buy or exercise the options contract, therefore, fulfilling your obligation. Expiration dates may range from weeks to months to years. Daily and weekly put options are risky and best suited for experienced options traders. Long-term investors can choose monthly or yearly expiration dates since they give your stock more time to move.
If you’re an options owner, here are 4 actions you may take regarding the expiration date:
- Sell it before the expiration date. The value of options changes daily and is driven by the underlying stock price. This value is reflected in the premium and you can decide to sell your option before its expiration date. The difference between how much you’re selling it and how much you paid for it is your loss or gain.
- Exercise it before the expiration date. You can exercise American style options any time before their expiration.
- Let it exercise automatically. Your brokerage may have a policy of exercising your options automatically if they expire and are in the money. Check your brokerage’s specific procedures and policies.
- Let the contract expire for $0 value. Your option contract is worthless if it expires out of the money.
Decide How Many Contracts
Each options contract represents 100 shares of a particular stock. You’ll also pay a premium for each contract to the seller. Depending on your brokerage’s fees and commission structure, you might also pay a per-contract fee. Your contract size will depend on how much money is available in your brokerage wallet as well as how much you’re willing to risk.
You’ll then use your brokerage’s trading platform to buy the options contracts you’ve chosen. Go through any resources available on your broker’s website to ensure you’re doing everything right.
Watch Stock Prices
After buying your options contracts, you’ll play a waiting game. Monitor stock prices to see if they move in the direction you predicted when you bought them. Most brokerages let you set alerts to notify you when stocks move below a certain price. You can exercise your options contract at any time prior to its expiration date.
Pros to Buying Put Options
Put options offer several advantages:
- A lower upfront financial commitment: The price of buying a put option is much less than what you would pay to buy shares outright.
- Limited risk: Buying a put option gives you unlimited potential profit while limiting the maximum risk to the price premium paid for an option. Similarly, an options seller has unlimited risk and profits by the amount of option premium collected.
- Leverage: Options buying lets you control a bigger stock position with less capital compared to buying the stock directly.
- Flexibility: When investing in stocks, you can only trade 2 directions — either up or down. Buying and selling options, however, offers a broader range of market conditions to trade.
- Income generation: Traders buy put options to help generate income. Various options strategies could also be used to allow you to collect option premiums.
- Hedging: If you have a portfolio of stocks, buying put options can help mitigate risk in case of a market downturn.
Cons to Buying Put Options
On the flip side, consider the following cons:
- Time: Put options have a time value that’s constantly decaying. You must be in the money — by expiration date — to profit.
- Leverage swings both ways: Although this is an advantage if you are correct, option trades can take a massive hit when you’re wrong.
- Additional costs can affect your profits: Some trading strategies may require you to set up a margin account to act as collateral should a trade move against your predictions.
How to Choose the Best Broker for You
How do you buy put options? How many contracts should you buy? Depending on the amount of support you need, you can choose either a discount or full-service broker.
Low commissions are just a fraction of what you need to consider when choosing the best broker for options trading. Consider your trading style as well as the features that are important in maximizing your profits. Research multiple brokerages to better understand the services offered by each. Online reviews may have information to consider if you can’t get a personal recommendation.
Learn More About Options Trading
Options trading isn’t as straightforward as stock trading. There’s a lot to educate yourself about. Watch tutorial videos, take lessons, download books and track the world news. If you’re a rookie trader, seek guidance from an experienced trader or mentor.
Whether you’re just getting started or you’re an experienced investor looking to explore, the skills needed to profit from options trading must be continually developed. With practice, you’ll get a better grasp of options trading concepts, better understand how to manage trading risks and learn to modify your trading strategies. So step up and explore!
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