Who Should Consider Buying Equity Puts?
- An investor who is very bearish on a particular stock and wants
to profit from a decline in its price.
- An investor who would like to take advantage of the leverage
that options can provide, and with a limited dollar risk.
- An investor who anticipates a decline in the value of a
particular stock but does not want the unlimited upside risk or the
commitment of capital needed for a short sale of underlying shares.
Buying an equity put is one of the simplest and most
popular strategies used by bearish option investors. It allows an
investor the opportunity to profit from a downward move in the price of
the underlying stock while committing less capital compared to the
potentially significant initial margin requirements needed for a short
sale of an equivalent number of underlying shares, usually 100 shares
per put contract. In addition, a long put holder is not subject to
margin calls with an increasing underlying stock price as is an investor
with an equivalent short stock position.
Definition
Buying an equity put gives the owner the right, but not
the obligation, to sell 100 shares of underlying stock at a specified
price (the strike price) at any time before a specific time (the
expiration date). This is a bearish strategy because the value of the
put tends to increase as the price of the underlying stock declines.
This gain in option value will increasingly reflect a decline in the
value of the underlying shares when the stock's market price moves below
the option's strike price.
The profit potential is significant as the underlying stock continues to
decline, and is limited only by a potential decrease in the stock's
price to no less than zero. The financial risk is limited to the total
premium paid for the option, no matter how high the underlying stock
increases in price. Investors find this limited risk more attractive
than the unlimited upside risk incurred from selling 100 shares of stock
short. In addition, a short seller of underlying shares must pay any
dividends distributed to shareholders while the short position is held;
a put holder does not. The break-even point is an underlying stock price
equal to the put's strike price minus the premium paid for the contract.
As with any long option, an increase in volatility has a positive
financial effect on the long put strategy while decreasing volatility
has a negative effect. Time decay has a negative effect.
Participate in Downward Stock Price
Movement With Limited Upside Risk
Please note: Commission,
dividends, margins, taxes and other transaction charges have not
been included in the following examples. However, these costs can
have a significant effect on expected returns and should be
considered. Because of the importance of tax considerations to all
options transactions, the investor considering options should
consult with his/her tax advisor as to how taxes affect the outcome
of contemplated options transactions.
Example
ZYX is trading at $52.00. However,
instead of selling 100 shares short an investor could purchase one
six-month ZYX 50 put, which represents the right to sell 100
underlying ZYX shares at $50 per share, for a quoted price of $3.00.
The total cost for the put would be: $3.00 x 100 contract multiplier
= $300. By purchasing the put the investor is saying that by
expiration he anticipates ZYX to have declined below the break-even
point: $50 strike price (at which price ZYX can be sold no matter
how low it has declined) - $3.00 (the option premium paid), or a ZYX
share price of $47.00.
The investor's profit potential can be significant as ZYX stock
price continues to decline below $47.00, and is theoretically
limited because a stock can decline only to zero. The risk for the
put purchase is limited entirely to the total premium paid for the
contract, or $300, no matter how high ZYX stock price might
increase.
Before expiration, if the put purchase becomes profitable the
investor is free to sell the option in the marketplace to realize
this gain. On the other hand, if the investor's bearish outlook
proves incorrect and ZYX increases in price, the put might be sold
to realize a loss less than the maximum.
Consider three possible scenarios at
expiration:
- ZYX closes below the break-even point
- ZYX closes between the strike price and the break-even point
- ZYX closes above the strike price
ZYX is below break-even point of $47.00
at expiration
If ZYX closes below the break-even point of $47.00 at
expiration, at $43 per share for instance, the option will be
in-the-money and worth its intrinsic value (difference between the
strike price and stock price):
$50.00 put strike price
-$43.00 ZYX stock price
$7.00 intrinsic value
If you sell the ZYX 45 put for its intrinsic value of $7
then you would see a profit:
$7.00 intrinsic value received at put's sale
$3.00 premium initially paid for put
$4.00 profit
This profit of $4.00 ($400 total) represents a return on
an initial investment of $3.00 premium paid for the put ($300 total) of
approximately 133% over the 6-month life of the put contract.
The put could also be exercised, and 100 shares of ZYX sold at the
contract's strike price of $50 per share less the $3.00 put premium
paid, or a net price of $47. However, if those shares aren't owned the
investor would then have a position of short 100 ZYX shares after
exercise. In addition to unlimited upside stock risk, the result of this
short stock position could be a potentially significant initial margin
requirement (which can vary greatly among brokerage firms) as well as
margin calls if ZYX increases in price. For this reason many investors
choose to simply sell a put that is in-the-money at expiration.
ZYX is between $50 and $47.00 at
expiration
With ZYX exactly at the strike price of $50 at
expiration, the 50 put would be exactly at-the-money and have no value.
With ZYX at the break-even point of $47.00 at expiration the put?s
intrinsic value would be $3.00, or its initial cost. With ZYX closing
between $50 and $47.00 at expiration, the 50 put will be in-the-money
and have an intrinsic value of less than its initial cost. In this case
the option could be sold to recoup some of its original purchase price
resulting in a partial loss for the position.
For example, ZYX closes at $48 at expiration. The put?s intrinsic value
at this point would be:
$50.00 put strike price
-$48.00 ZYX stock price
$2.00 intrinsic value
ZYX did decline in value, but not as much as
anticipated. The option that cost $3.00 is now worth $2, so the investor
can sell the put and recoup some of its initial purchase price. If the
ZYX 50 put is sold for its intrinsic value of $2 then the loss for the
position would be:
$3.00 premium initially paid for put
$2.00 premium received at put’s sale
$1.00 loss
The put could also be exercised. 100 shares of ZYX would be sold at the
contract?s strike price of $50 per share less the put premium paid, or a
net price of $47 per share. But if those shares aren?t owned, the
investor would then have a short stock position along with its inherent
margin requirements, possibility of margin calls, and unlimited upside
stock price risk.
ZYX is at or above $50 at expiration
Say ZYX stock did not move as anticipated, but instead
increased and closes at $57 per share at expiration. The ZYX put would
expire out-of-the-money and with no value, so the investor would lose
the total premium of $300 initially paid for the option. This would be
the limited, maximum loss no matter how far ZYX stock had risen, and
would also be realized if at expiration ZYX closed at any point at or
above the $50 strike price and the put expired out-of-the-money.
Had the investor initially chosen a short sale of 100 ZYX shares as
opposed to purchasing the $50 put when ZYX was trading at a price of
$52, he would also incur a loss with ZYX trading at $57. However, the
investor would have unlimited risk above this price level, and there is
no theoretical limit as to how high a stock price can increase.
Summary
For those who are very bearish on a particular stock
over the near- or long-term, and who require a known, limited upside
risk, buying a put might be an appropriate strategy to use.
Purchasing a put option usually requires a smaller initial cash
investment than the margin requirement for a short sale of stock. In
addition, there are neither margin calls, nor does a put holder pay
any dividends. This reduces the capital at risk and offers the
potential of leveraged profits if a bearish opinion proves correct.
As the underlying stock continues to decrease, the long put's profit
potential is limited only by the underlying stock declining to zero,
and large returns on investment can be seen. On the upside, the
investor with a short stock position is exposed to a potentially
unlimited dollar loss from an increase in share value, while the put
buyer's maximum loss is known in advance and is limited entirely to
the option's purchase price.
Today's investor has a choice of shorter-term expiration months
afforded by regular equity option contracts, longer-term expirations
available with LEAPS®, as well as multiple strike prices. So no
matter an investor's anticipated target price for an underlying
stock after a bearish move, or the time frame over which this move
might occur, there is most likely a put contract that fits both his
outlook and tolerance for risk.
