PUT OPTION BASICS
I’ve written many articles highlighting the advantages options trading and how this technique, when deployed in opportunistic or conservative scenarios may augment overall portfolio returns while mitigating risk in a meaningful manner.
1) Why buy a stock now when you can purchase the stock in the future at a lower price while being paid to do so?
2) Why buy stocks at all when you can make money on the underlying volatility without ever owning the shares?
Timing the market has proven to be very difficult if not altogether impossible. However creating opportunities to lock-in downward movement in a given stock one is looking to own is possible. If a stock of interest has substantially fallen to at or near a 52-week low, then one has an option to “buy” the stock at an even lower price at a later date while collecting premium income in the process. Alternatively, it's also possible to make money on the option itself without owning any shares of the company via realizing options premium gains as the underlying stock appreciates in value off its lows. This is called a covered or secured put option, covered in the sense that one has cash to back the option contract. Leveraging covered or secured put options in opportunistic scenarios may augment overall portfolio returns while mitigating risk when looking to initiate a future position in an individual stock. In the event of a covered put, this is accomplished by leveraging the cash one currently has by selling a put contract against those funds for a premium. It's also possible to make money on the option itself without owning any shares of the company via realizing options premium gains as the underlying stock appreciates in value.
Selling a put option will take on the obligation to purchase the shares of interest which currently trade at $100 per share. For instance, he/she decides to sell a put option at a strike of $95 for $2 per share premium for a one month contract. The option seller takes on the obligation to buy the shares at $95 (effective price would be $93 including the $2 per share premium paid upfront) a month from now when the current price is $100. The seller of the put contract believes the shares will trade sideways, appreciate or decline but not decline below $95. If the stock remains above $95 through expiration then the owner of the shares could not exercise the option and assign shares since the price is not in-the-money. In this case, the put option seller collects a premium from the put option buyer and makes money without owning any shares. From the stock owners perspective, he/she is buying the right to sell the shares at $95 a month from now when the current price is $100. The buyer of the put contract believes the shares will fall below the $95 level. Thus the owner of the shares would exercise the option and assign shares to the put seller if the shares fall below $95. Why sell the shares below $95 on the open market when the owner can sell them to the put seller for $95? This is effectively an insurance policy against the shares falling. In this case, the put option seller collects a premium from the put option buyer and assigned shares that may be significantly lower than the market price.
A Few Characteristics to Keep in Mind for Secured Put Options Trading:
1. Strike price: Price at which you have the obligation to buy the stock (seller of the put option) or the price at which you the right to sell your stock (buyer of the put option).
2. Expiration date: Date on which the option expires
3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.
4. Time premium: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility the greater the time premium received for covered call writing.
5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration, the option will increase in lock-step.