Buying Put Options for Gains - dummies

By Paul Mladjenovic

When you can buy put options and even long-term put options, why bother doing a short sale? A put option is a great vehicle for speculating that a stock or other security will fall in price in the near future.

Finding the “worst” candidate

When you’re researching put options to buy, keep in mind that you’re looking for a stock whose company has terrible fundamentals and whose stock price is much higher than the company’s intrinsic or book value. The ideal candidate is one that looks beautiful to the marketplace, but when you peel away the layers, you see true ugliness. In other words, think of a hot stock and find the company’s fatal flaws. Profitable companies are good to invest in; you should obviously avoid unprofitable companies as investments, but they can be candidates for put options.

Also, many exchange-traded funds (ETFs) are now optionable, so the put option speculator can seek industries and sectors that are good bearish candidates for put options.

Profiting when the market is “too high”

Part of successful put option speculating is choosing the right entry point. When you’re shopping for puts on an underlying stock or stock group that is rallying, the puts tend to be very cheap. The cheaper the put option, the less money you’re risking and the better chance you have of making money when the underlying asset reverses and heads downward.

If you see a bubble or a humongous rally in a particular stock or industry, don’t rush in immediately and buy dozens or hundreds of put options and then go shopping for a yacht, expecting a fortune waiting for you in your brokerage account. Sometimes bull markets, bubbles, or bear markets last longer than your options. Experienced speculators buy a few puts, wait for confirmation of their expectations, and then buy some more.

Recognizing the gains you can get from exits

Although put options are generally a mirror inverse of call options, some things are a little different. One difference is the speed of bullish and bearish markets, which could be a plus for put speculators.

The most extreme and euphoric bull market rallies don’t typically move as hard and as fast as an extreme bear market correction. In those moments, the movement sure doesn’t feel like a correction; it feels extremely incorrect to bulls! The point is that investors and speculators move faster when they’re driven by fear than when they’re driven by greed.

Participants move faster and in greater volume when they’re heading toward the exit than when they’re heading toward the entrance. Many of the most spectacular and timely gains come with puts rather than calls.

Understanding the golden rules for put option buyers

Some of the following rules for put option buyers may mirror my golden rules for buyers of call options, but I include them for completeness. Of course, the put is the opposite speculation from a call:

  • Puts can expire worthless if you aren’t careful.

  • Your expertise, proficiency, or research should not be tied to the put itself; it should be on the underlying asset. As a derivative, a put option (just like a call option) doesn’t have its own value.

  • There are options on all sorts of securities and assets, so make sure you specialize. Don’t try to master stocks and commodities and currencies. The most successful practitioners focus on a particular asset class and know it inside and out.

  • After you master a particular asset class, become proficient in a few basic option strategies. For some folks, just mastering put option spreads makes a huge difference in their overall success.

    To better understand option strategies, try simulated trading before you risk real money, especially if you’re inexperienced. In fact, you can do simulated trading without resorting to fancy programs. Just choose a few candidates for your put options, head over to the quote tables at the Chicago Board Options Exchange website, and view all the possible puts (and calls, too) for your chosen stock or security. You can download the entire list of quotes and then import the data into your favorite spreadsheet program. Do this on a weekend, when markets are closed. Then do it again in, say, two weeks, and see which puts and put strategies would have made money.

  • When choosing which put option to buy, get the longest time frame that you can afford. The longer the time frame, the greater your chances of success.

  • If you choose an out-of-the-money (OTM) put, it’s better to get one that’s really close than two that are far away. Get closer to the money, and you increase your chances of success. Use this golden rule to augment the preceding rule.

  • Use technical analysis where applicable. The Relative Strength Index (RSI) is a great tool. The optimal time to buy puts on a stock or asset is when it’s overbought (having an RSI reading of over 70).

  • Unless you’re desperate to buy a particular option and need to do a market order, do a limit order to get a better price. If an option has an ask price of $1.50, for example, do a limit order for $1.50 or even a little lower. You have a strong chance of getting your price most of the time, especially if the trading session isn’t volatile.

  • Be a contrarian where possible. Where is the exuberance and jubilation? Overwrought markets do tend to reverse in due course.

  • Consider the preceding point in relation to the broader picture. Buying puts is more successful in a general bear market than in a general bull market. Understand the difference between bull and bear markets so you don’t end up buying lots of put options that expire worthless.

  • Stagger your option purchases if possible, especially if you’re a novice and need to slowly test the markets. For example, if you’re devoting $5,000 to buying put options, consider deploying a third now and the rest later, after a few weeks of watching the trading action.

  • Diversify your options, even if you’re speculating. Consider different options on different securities; have some bullish strategies and some bearish as well. This increases your chances of having winning positions in your portfolio.

  • Consider option combinations. Besides the put option, other bearish combinations could be good strategies, given certain market conditions.