put option: pros and cons

Most investors watch the stock market fall and grumble about how much money they are losing.

During these times, dollar cost averaging doesn't seem to soothe the soul.

Buying Put options completely eliminates that helpless feeling.

You feel more in control because you are able to make money on the way down.

Buying Put options are a way to profit from a downturn in the stock market without shorting the stock. Short selling is beyond the scope of this lesson however if you understand the concept of shorting stocks it will help you to understand the power of Put options.

In the previous two lessons we discussed how Put options are used as a hedge (insurance) against a decline in stock price. This lesson focuses on yet another use, buying Put options to trade them for a profit.

You are going to buy Put contracts that you think will increase in value. Once they do increase in value you will sell them at a higher price and pocket the difference.

Buying Put Options...

A Put option gives its buyer the right, but not the obligation, to SELL shares of a stock at a specified price on or before a given date.

Buying ONLY Put's should not be confused with Married Puts or Protective Puts. Married and Protective Puts are purchased to protect shares of stock from a sharp decline in price.

The major difference between the two is with Married/Protective Puts there is "ownership in stock".

Buying Put options involves just that, buying only the Put option.

When you buy only the Put option it completely changes the dynamics of the trade. You want the stock price to fall because that is how you make your profit.

In "most" cases you never intend on exercising your rights to sell the stock. You just want to benefit from the movement of the stock without having to own the stock, and you can do this with Put options.

A put option locks in the selling price of a stock.

So if you buy an option with a strike price of $70 this will allow you to sell the stock for $70 anytime between the day you buy the option and when it expires.

So if the stocks falls to $60 your put option will go up in value. Why, because you hold a contract that gives you the right to sell something for more than its market value.

Yes this seems unfair and logically this doesn't make sense, but this is just the nature of the terms of the option contract.

It's like baseball cards. Baseball cards are literally pieces of cardboard, yet some of them can sell for thousands of dollars because there are only a limited number of them in the world. Because only a limited number are available it makes the cards more valuable.

With a put option you hold a contract that lets you sell something for MORE than it's worth. This makes your contract more valuable so you essentially turn it around and sell it at a higher price.

Advantages of Buying Put Options...

• Allows you to participate in the downward movement of the stock without having to own or short the stock
• You only have to risk a relatively small sum of money to buy a Put Option
• The maximum amount you can lose on a trade is the cost of the Put
• Leverage (using a small amount of money to make a large sum of money)
• Higher potential investment returns

Disadvantages of Buying Put Options

• The Put option has an expiration date so time works against you
• The stock has to make a move downward in order for the Put option to increase in value
• If the stock stays flat or doesn't move, then the Put option will lose value due to time decay.