How to trade put options best
Put options are basically the reverse of call options. A call gives the owner the right to buy stock at a given price that is the strike for a certain period of time.
A put, on the other hand, gives the owner the right to sell stock at the strike price for a limited time.
If you do not like the risk of a naked put you may create a put spread instead.
Let’s discuss owning puts first, followed by holding a short put position.
Buying Put Options
If you own a put on stock XYZ, you have the right to sell XYZ at the strike price until the put option expires. Your maximum possible profit is obtained if the stock declines all the way to zero. On the other hand, the maximum potential risk is losing the entire premium paid to purchase the option. This happens if the stock is at or above the strike price at expiration.
A Simplified Example: Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.
Selling Put Options
Instead of purchasing put options, one can also write options and receive option premium. When you write or sell an put options, you are short one put options.The best time to sell options is when Implied Volatility is high, These options will be rich in premium. Put writers sell put options with the hope that they expire worthless so that they can pocket the premiums.
If you sell a put option on stock XYZ, it means you take on the obligation to buy XYZ from the put owner. You can buy it at that strike price if the owner decide to exercises his right before option expiration. In return, you will receive option premiums in exchange for taking on the obligation. The Option Premium that you have received is also the maximum profit for this trade. This will happen if the stock is at the strike price or higher. At expiration, If the stock price drops and reaches the strike price you can still be in profit. Only if the stock price drops below the break even (strike price less the premium you received) you do have a loss. In theory the stock can go to zero and have unlimited loss. Brokers think that the risk is less though. Have a look at your buying power reduction to get an idea how much the risk is. Although the risk is not so much as you would have expected, keep your trading size small. Do not enter too many positions.
We like to sell out of the money put options and receive option premiums. When the underlying price increase, the option price will drop. Typically we hope that the option will decay and expire worthless or that we can buy back the option within a few days and make 25-50% profit.
A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.