Stock Prices Dropping? Here's Why Buying a Put Option Makes Sense!

Suzanne is a skilled content marketer, writer, and fact-checker with a Bachelor of Science in Finance from Bridgewater State University. She specializes in crafting effective content strategies.

Investors often purchase put options when anticipating a decline in the stock market. A put option grants the holder the right to sell an underlying asset at a predetermined price within a set timeframe, typically increasing in value as the asset's price falls.

Owning a put option allows you to benefit during market downturns—whether you're speculating on a decline or hedging against losses in your portfolio.

Whether you're managing a diverse stock portfolio or simply want to bet on falling prices, buying put options can be a strategic move.

Key Points to Remember

• A put option provides the right, without obligation, to sell an asset at a fixed price before expiration.
• Protective puts serve as insurance for existing holdings, while long puts are used to speculate on price drops.
• The value of a long put depends on the stock price, its volatility, and time remaining until expiration.
• Long puts can be closed by selling or exercising, but exercising early often sacrifices remaining time value.

Speculating with Long Puts vs. Using Protective Puts

Investors buying puts to speculate expect prices to fall and aim to profit from that decline. Conversely, protective puts are purchased to safeguard existing investments; the investor hopes prices rise but buys puts as a safety net in case prices drop. If the market declines, the put's value offsets portfolio losses.

When opening a long put position, investors "buy to open." This term distinguishes initiating a new position from "closing" a previously opened short put position by buying it back.

Practical Insights

Besides buying puts, short selling is another common method to profit from falling stock prices. Short sellers borrow shares from brokers, sell them, and later repurchase at a lower price to return the shares, profiting from the difference.

Some stocks on exchanges like NYSE or Nasdaq may not be available for short selling due to limited shares to borrow. In such cases, buying put options can offer a way to profit from expected declines.

Not all stocks have listed options, so puts may not always be available. However, puts generally carry less risk than short selling since the maximum loss is limited to the premium paid, while short sellers face unlimited risk if stock prices rise.

Option premiums rise with increased volatility, making puts more expensive in uncertain or volatile markets. Always weigh the costs against potential benefits before executing any trading strategy.

Example Scenario: How Puts Work

Imagine stock ABC trades at $100 per share. One-month put options with a $95 strike price cost $3 each. An investor expecting ABC's price to drop can buy these puts for $300 (since each contract controls 100 shares).

The breakeven price at expiration is $92 per share ($95 strike price minus the $3 premium). If ABC falls to $92, exercising the put yields no profit or loss. Profits increase if the stock price drops below $92. For instance, at $80, the profit is $12 per share after accounting for the premium paid. The maximum loss is limited to the $3 premium if the stock stays above $95.

Unlike call options, where profits can theoretically be unlimited, put options have a maximum payoff capped at the strike price since a stock cannot fall below zero. For ABC, the maximum put value is $95 if the stock becomes worthless.

Closing vs. Exercising Your Put Option

To exit a long put position, you can either sell the option or exercise it. Suppose you own ABC puts purchased at $3, and the stock price drops to $90, increasing the put's market price to $5. Selling the puts yields a $200 profit.

Important Note

Stock options can be exercised any time before expiration, though some index options only allow exercise at expiration.

Exercising the put involves buying shares at the current market price ($90) and selling them at the strike price ($95), resulting in the same $200 profit.

Since options have time value in addition to intrinsic value, it is often more profitable to sell the put rather than exercise early and forfeit remaining time value. For example, if the put is priced at $5.50 with $5 intrinsic value, the extra $0.50 represents time value that would be lost upon exercise.

Discover the latest news and current events in Options & Derivatives Trading as of 18-01-2022. The article titled " Stock Prices Dropping? Here's Why Buying a Put Option Makes Sense! " provides you with the most relevant and reliable information in the Options & Derivatives Trading field. Each news piece is thoroughly analyzed to deliver valuable insights to our readers.

The information in " Stock Prices Dropping? Here's Why Buying a Put Option Makes Sense! " helps you make better-informed decisions within the Options & Derivatives Trading category. Our news articles are continuously updated and adhere to journalistic standards.