Buying an In-the-Money Put
If you are bearish on a stock, you could choose to buy a put to take advantage of the downward move. If you buy an in-the-money put, or a put whose strike price is above the price of the underlying stock, the value of the option will move up and down at roughly the same dollar amounts as the underlying stock moves down.
I say roughly because the amount the option moves is actually some fraction of the amount the stock moves, depending on how close the option is to at the money. This fraction is called delta and it approaches 1 the further you go in the money. So if an option has a delta value of 0.85, for every dollar that the stock goes down, the put option will go up by 85 cents, and for every dollar that the stock goes up, the put option will down by 85 cents.
For example, imagine that you buy a put option with a strike price of $40 on a stock that currently costs $35, and you pay $7.00 for the put ($5.00 intrinsic value, $2.00 time value). If the stock goes down to $30, it has decreased in value by about 14%. This is the amount you would have gained if you had shorted the stock. However, depending on how long the move took, the put could now be worth between $10-$12. That gives you a gain of 42%-71%.
However, you can also lose your money fairly quickly. If the stock were to go up to $40, the most you stand to recover is any time value that is still left in the option. It’s quite possible to lose 100% of the value of the option.
Buying an Out-of-the-Money Put
You can also choose to buy an out-of-the-money put option. These options are much cheaper than the in-the-money puts. However, this strategy carries a lot more risk because the option has no intrinsic value. Therefore, the only way you can make money is if the stock decreases in value enough past the strike price of the option to make up for the lost time value (assuming you hold the option until expiration).
For example, if you buy a put option with a strike price of $30 on a stock that is currently worth $35, it might cost you around $2.00 (depending on many factors such as how much time is left until expiration). In order for this option to be profitable at expiration time, the stock must have fallen to at least $28. So a reduction of 20% on the stock simply gets the option to break even. If the stock were to decrease beyond that, the option could go on to have much higher gains. However, the most likely outcome is that the option will expire out of the money, or worthless.
Selling a Covered Put
If you a own a short position on a stock but now think the stock is not going to go down in value, one way that you can still profit from it is to sell covered puts. Remember that buying a put gives you the right to sell the underlying stock at the strike price of the call until its expiration date. Conversely, the person selling the put has an obligation to buy the underlying stock at the strike price, if the option is exercised before its expiration date. If the option is never exercised, it becomes worthless and seller keeps the premium that was paid for it as profit.
For example, if you are short on a stock that is worth $43 and you don’t think it is going to down in value, you could sell the $40 put option. You would sell 1 contract for every 100 shares that you want to include in this trade. If by the expiration date of the option, the stock is worth $40 or more, you get to keep the premium. However, if the stock has dropped below $40, you must either buy back the options at a loss, or simply buy to cover your short stock at $40.
Note that even if you get put the stock, you still make a profit. You get both the premium that is paid for the put option, as well as the $3 gain on the short position - from $43 to $40.
Selling a Naked Put
Selling a naked put is similar to selling a covered put, except that you haven’t shorted the underlying stock. That makes this type of trade very risky. Consider the previous example where you sell a $40 put option on a stock that is currently worth $43. If the stock were to plummet to $1 before expiration, you would be forced to buy the stock for $43 and the most you can get for it in the market is $1.
