Amongst derivatives contract – options are the most complex and the most used instruments. In addition, amongst options – put options are the most sought after contracts.
In this article, we will take a closer look at put options and its varied uses; some of which on how to generate regular income or bring down your stock/index ownership cost.
What is put option in stock market ?
you can skip this section if you are well aware of the basics.
put option is a bet on the underlying stock or index going down.
It is a part of the derivatives segment.
When you buy a put option – you are paying premium. Put option – and other options, come with strike price – the level at which decides if you won the bet or not at expiry.
On the other side, if you are a put option seller – you are receiving premium. And again, put option strike and underlying movement will decide who is the winner at expiry.
Buyer of any option has to bring in just the premium. He/she is risking only the premium paid. Nothing more.
put option with example
example with ford stock.
Put option buy or sell?
Which put option to buy?
Index put option to buy for hedging strategy of your portfolio.if you have stocks in your portfolio and feel the need to protect them individually, you can consider buying a put option. in such cases you could consider Leap option
Put option vs. short position
as explained above, owning a put option is about deciding on strike of put option and paying premium. No more risk other than 100% loss of premium paid.
Short stock position – shorting a stock happens when you may or may not have stocks in your position. You end up borrowing stocks to short for a fee. If your view turns up good – you make money (short stock price – repurchase price = profit).From risk perspective – buying a put option is safer. Short stock/index position can expose you to high risk. You may have to bring in more cash margin in case the stock moves significantly higher.
Put option vs. inverse ETF
Inverse ETF also known as “Short ETF,” or “Bear ETF” is an instrument that consists of derivatives – mostly futures. This ETF rises in value when market declines. But given the frequent churning in the ETF, the costs/fees goes up.
Put option is preferred if you with to hedge your portfolio.
Put option for hedging
Put option pays off when the stock/underlying drops below the strike price. If you hold a stock portfolio of significant amount, you might consider purchasing insurance i.e put option. you can either purchase an index put option or individual stock put options.
how many put options to purchase ? here is the formula to calculate.
Put option vs. stop loss order
Put Option buying for hedging vs. placing a stop loss order for your portfolio purely depends on how good your broker systems are and how guaranteed is the execution of your stop loss order will be in case of a flash crash.
It pays to buy a put option rather than depend on stop loss order.
Put option for monthly income or to buy stock
let’s say you like Coca Cola stock and believe like Mr. Warren Buffet that this company is here to stay for a looong time. And you want this stock to be a part of your core portfolio. you have 3 ways to go about buying Coca Cola shares:
- buy the shares right from the market by paying cash.
- buy a call option of coca cola by paying premium. the premise here is that you believe coca cola stock price will move higher and you don’t want to use full cash to take position. Here you pay a small premium and get to take part in full gain if the stock were to move up quickly.
you sell put option. you get premium. if stock dips below strike sold, you get assigned and you get to buy your favorite stock cheaper. if the stock does not drop below strike, you get to keep the premium received. Rinse and repeat.
Put option can be put to various uses, one of them is to make monthly income while you wait to be assigned your favorite stock.
you could pick 2-3 high quality stocks and write a put option on them with the intention of owning them. If you get assigned, you get the stock. If not, you get to keep the premium. This is monthly income at its best.
what strategy do you follow?
for more techniques on Put option selling, churning monthly income, I recommend the following books from Amazon.