Foundations of Trading: Options [Part 6]

Our Foundations of Trading Options blog series continues today with coverage over class 4. In last week’s blog, we covered a few thoughts from Chris regarding his Long Calls Strategy presented in FoT Options Class 3. In short, this is a strategy you can use when you feel a company’s stock is bullish. However, what if you feel a company’s stock is bearish and likely to go down in the days and weeks ahead. That is what Chris covers in today’s blog as we look at the long put strategy.

Again as a point of review, a call option gives you the right to buy a stock at a specific price. The monetary value of a call option increases as the value of the underlying stock increases, which means call options are bullish in nature. These options are valuable to short-sellers as they function as a type of price insurance. On the flip side, a put option gives you the right to sell a stock at a specific price. The monetary value of a put option increases as the value of the stock decreases, which means ​put options are bearish in nature. These options are valuable to long buyers as they function as a type of price insurance.

Now, let’s look at a long put example that Chris presented in class 4.

Let’s say you’re bearish on AAPL. By buying the 172 strike put option, you reserve the right to sell AAPL for $172 a share. If AAPL goes to $160 or even lower, you still have the right to sell shares for $172. If you think AAPL could drop to $160 in the next few weeks, how much would you pay for the right to sell AAPL at $172?

Now, we agree that being able to sell at $172 is worth at least $12 when AAPL is trading at $160, right? That’s because you could buy shares in the market at $160 a share, then immediately turn around and exercise your right to sell those shares at $172 a share, netting yourself an instant $12 profit. So if AAPL went all the way down to $152, how much would it be worth to have the right to sell at $172? If your answer is $20, you would be correct.

The lower AAPL goes, the more valuable the right to sell back at the $172 price point becomes. Just like with a call option, our put option gains more value as the stock moves in our favor which, in this case, is bearish. Our profits are “technically” limited because the stock cannot drop below zero. And just like when you bought a call option, you cannot lose more than you paid for the put option.

Let’s say the $172 strike put option costs $7.50 a share. This means that the most you could lose on this trade is $7.50 a share, no matter what the stock does. Compare that with shorting the stock, where your risk is unlimited. By buying a put option, we still get to participate in the same downside move as if we had shorted the stock. However, at the same time, we limit our risk to only a fraction of what we could lose on an actual short stock trade.

Rather than needing $8,600 of margin, $172 x 100 x 0, too short 100 shares of AAPL, we can control the same shares by spending only $750 for a put option. We enjoy leveraged profits if AAPL decreases for only a fraction of the risk. Thus, if AAPL goes to $160 by expiration, the 172 strike puts that we paid $7.50 a share for will be worth $12 a share which is a +73% return. If AAPL goes to $152 by expiration, the puts will be worth $20 a share which is a +166% return.

You would buy puts when you expect the stock to go down in price as a long put option structure is another way to express a bearish view of a stock. And remember to always purchase more time than you need as it gives your trade more time to be right and helps to mitigate the effect of time decay and keep the odds in your favor.

I​n Closing

If you need or wish to revisit any part of our current options journey, please click on the Foundations of Trading blog category on the right-hand side of the page, which will instantly bring up all the blogs from our program for your review. And finally, if you have any questions regarding the contents of this blog, please stop by to see our teachers and moderators in our Group Coaching sessions which happen every Thursday, and have Chris dive a little deeper into his example. For access, please contact Rebekah at info@tradesmartu.com for details on Group Coaching sessions. Thank you for reading, and we look forward to seeing you next week!