A few weeks ago we outlined five strategies for using call options. But that’s one side of the market.
On the other side, equity traders who want to reduce the risk of shorting stocks often turn to put options as a way to mitigate risk, create more precise trading strategies or simply make speculative bets on stock downside. Here’s a quick look at 5 basic put option strategies. For more details on each, check out our education center.
The most basic of all put option trading strategies is the long put strategy. This approach simply involves buying put options as a bet that the underlying stock will decline below the strike price of the option before its expiration date. The reasons for using a long put strategy are similar to those for short selling a stock. However, the long put strategy caps potential risk at 100 percent, whereas shorting a stock has theoretically unlimited risk.
The protective put strategy is a way to protect yourself in the event of a downturn in a stock you already own. By buying a cheap put option for this stock, you are essentially buying an insurance policy on your long position. Ideally, you will not need this insurance policy if the stock rises as predicted. However, because the protective put profits if the stock falls, it can provide a good hedge.
Traders utilizing a bear put spread strategy purchase put options at a specific strike price and expiration date while simultaneously selling the same number of put options for the same date at a lower strike price. As a result, the overall cost of the bearish bet is reduced by the profits from the put options sold. The caveat to the trade is that potential profits are capped once the stock price drops below the strike price of the puts that are sold.
The bull put spread strategy involves purchasing put options at a low strike price while simultaneously selling the same number of put options for the same expiration date at a much higher strike price. When you initiate the trade, the puts sold at the higher strike price will always generate more income than the puts purchased at the lower strike price. If the share price of the underlying stock trades higher than the strike price of the puts sold, the sold puts expire worthless and you keep the profits from the sale. If the stock trades lower, the puts purchased mitigate the downside risk.
If you’ve got a specific price target for a stock and a specific date in mind for a trade, a long put butterfly can be the best way to use put options to make a big bet on a stock at a relatively low cost. To initiate a long put butterfly trade, sell two put options with a strike price equal to your target price for the stock.
Next, buy one put option at a lower strike price and one put option at a higher strike price, both equidistant from your target price. Ideally, the stock will hit the target price and the put options sold will expire worthless. The put option purchased at the lower price will also expire worthless. However, the gains from the put option purchased at the higher price coupled with the income from the two puts sold will generate an overall net positive return on the trade. The long put butterfly generates maximum profits if the stock trades to exactly the strike price of the pair of put options initially sold.
To learn more about basic option trading strategies and see examples of how to execute option trades, visit the Lightspeed option trading education center.
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