Wednesday, October 17th, 2018

When is Trading Put Options a Good Option for an Options Trader?

November 24, 2009 by T.D. Thompson  
Filed under Options Trading Tips, Put Options

 

For many the best option for making money in the stock market is in trading options. Options traders both buy and sell options. They sell calls and puts. That is to say options traders sell rights and options to buy or sell. Which an options trader does is based upon his or her read of the stock in question, whether it is likely to go up or down and when.

What is a put option and when does a options trader buy or sell put options?

When an options trader thinks that a stock will go up in price he could buy the stock or, for much less, sell a put. When the trader sells the put option he or she receives a premium and undertakes the obligation to buy the stock at an agreed upon price, the exercise price or strike price if the buy wishes. If the price of the stock goes up the buyer of the put will not want to sell and the seller of the put will gain the premium.

If, on the other hand the stock price drops the put buyer will want to exercise his right and the sell will have to buy the stock at the exercise price when, indeed, it may be worth substantially less. Selling a put when one does not have the cash to cover a loss is called an uncovered put or naked put. The downside potential on an uncovered or “naked” put can be the exercise price of the stock if the stock itself goes to zero.

Options traders can buy and sell puts. Buying a put is often a defense strategy for the owner of a large stock position after a substantial run up and a very volatile market. Buy paying the cost of the put the stock owner protects his or her position against substantial loss. Because the buyer of the put is under no obligation to sell his or her stock he or she can pay a little “insurance” to protect a stock position against loss and still control the stock if the price, in fact, goes up.

More complicated approaches to put options are approaches such as long straddles where the options trader will purchase both a call option and a put option on the same stock at the same strike price. The options trader can make money if the stock moves substantially in either direction, and will only lose the price of the options if the stock stands still.

In the case of buying and selling put options a stock owner may be protecting a stock position or a stock trader may be looking to leverage a small amount of capital into a large gain such as with a long straddle. In the case of selling a naked put the options trader is betting on gaining the premium and not losing his or her shirt with a precipitous drop in the stock price.

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