Prices Plunging? Buy A Put!

By Investopedia Staff AAA

As you become more informed about the options market, you will need to learn how to use a long or short position in either a rising or falling market. Going long on a call is a profitable strategy when the underlying stock price rises in value, but how can you make money on a falling stock? By going long on a put. Puts are essentially the opposite of calls and have different payoff diagrams. Read on to find out how they work - and how you can profit. (For more information on the long position, see Going Long On Calls.)

Put Your Money Where Your Mouth Is
Going long on puts should not be confused with the technique of married puts. Married puts are for protecting shares from a sharp decline in value with the purchase of puts on those shares. (For additional reading, see Married Puts: A Protective Relationship and Cut Down Risk With Covered Calls.)

Here, we focus on buying puts as a means to speculate on falling share prices. The major difference is that there is no ownership in the underlying shares - the only ownership is in the puts. Opening such a long position in your brokerage account involves "buying to open" a put position. Brokers use this confusing terminology because when you buy puts, you can be buying them either to open a position or to close a position. Opening a position is self-explanatory, but closing a position simply means that you are buying back puts that you had sold earlier. (To continue reading on calls, see Naked Call Writing and To Limit or Go Naked, That Is the Question.)

Practical Considerations

Besides buying puts, another common strategy used to profit from falling share prices is selling the stock short. You do this by borrowing the shares from your broker and then selling them. If the price falls, you buy them back at a cheaper price and return them to the owner while keeping the profit.

Buying puts instead of shorting is advantageous for the same reasons that buying calls is more advantageous than buying stocks. In addition to leverage, you also get the ability to buy puts on stocks for which you cannot find the shares to short. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because your broker does not have enough shares to lend to people who would like to short them. In such a case, puts become very useful because you can profit from the downside of a "non-shortable" stock. In addition, because the most you can lose is your premium, puts are inherently less risky than shorting a stock. (To learn more about this concept, see Reducing Risk With Options.)

An Example: Puts At Work
Let's consider stock ABC, which trades for $100 per share. Its one-month puts, which are at a strike price of $95, trade for $3. An investor who thinks that ABC shares are overvalued and will fall below $92 within the next month will buy the puts at $3. In such a case, the investor must pay $300 ($3 x 100) for the put, which is illustrated in the payoff diagram shown in Figure 1, below.

Figure 1
Copyright exercise the put, you would go to the market and buy shares at $90. You would then "put" (or sell) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit in this case is also $200.

The distinction between a put and a call payoff diagram is important to remember. When dealing with long calls, the profits you might obtain are limitless, because a stock can go up in value forever (in theory). However, a payoff diagram for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95, because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0!

To Put Or Not to Put
Puts are a very useful way profit from a fall in stock price. Such a position has inherent advantages over shorting a stock, but investors must be careful not to over-leverage their positions. If used properly, puts are an excellent way to profit from downside because your losses are limited to your option premium.

To continue reading about puts, see When does one sell a put, and when does one sell a call?

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