Making Use Of Put Options
Put options give you a right to sell the shares of stock (or other financial assets) underlying the option contract at an agreed upon price, called its “strike price,” by a predetermined expiration date. Adding put options to your investment strategy, in bearish market environments, can be a smart way to go about hedging the risk that’s always present in most markets.
Hedging in Bear Markets
When you add put options to your investment portfolio you’re basically engaging in a bearish strategy that’s speculating, or betting on, a potential decline in a particular security, such as an energy stock, or index. You can also use put options to hedge against risk to the “downside” (a decline) in your portfolio.
Smart investors always have a plan to reduce or hedge against their risk even during go-go bear markets. If after study and consideration you find yourself none too confident about a security, an index or a particular stock you should seriously consider hedging through use of put options.
Directly Hedging Risk
If you have a large and diverse portfolio of investments and you’re worried about it losing some of its value through market declines you can directly hedge against that same risk. Continuing with the energy stocks example above, you could buy “puts” (put options) on the energy stocks you have in your portfolio. Should those energy stocks suffer a decline they’ll lose value and, as a consequence, so will your portfolio.
However, because you hedged through use of puts your loss would probably be negated and you may even improve the actual value of your total portfolio. At worst, all you’d lose is the premium you paid to purchase those put options. You didn’t actually purchase the stocks themselves, though; just the right to sell them, and you’d only do that if the underlying stocks declined sufficiently in price.
Cost of Put Options
As with call (buy) options, the cost of the put option is the premium you pay to purchase the right to sell the stocks underlying the put. Unlike when short-selling actual stocks, you won’t have to fund a margin account, although if you act as the put writer, meaning you’re the one selling the put option contract to an investor, you’d have to supply the margin. Because you don’t have to fund a margin account -- something that’s required by the brokerage firms that are licensed to handle such trades -- your cost to make use of put options is often far less than short selling stocks themselves.
You also don’t actually need a great deal of capital to initiate or take a put position and stories abound of put buyers turning $100 or $200 into thousands. Put options, though, are time sensitive and time won’t be on your side when you initiate such positions (unlike when you “go long” or take a long-horizon position on an actual stock). The risk in initiating put option positions is that such trades may not work out (and they probably WON’T) and you could lose all the capital you invested.
Engaging in Put Option Trading
Call and put options are derivatives of stocks or other financial securities and they’re not to be taken lightly. Enter into such trading strategies only after you’ve become thoroughly familiar with how options work. Fortunately, there are many resources available for helping you gain such familiarity. At minimum, spend several weeks taking online tutorials or discussing such matters with options trading experts before you try it for yourself.
For further study on put options try these excellent resources: