Options are an excellent way to manage a big piece of shares without putting up the capital required to own shares of more significant stocks. Buying a put option is preferred by numerous investors as it helps to hedge your stock financial investments. This post will tell you all the details about put options. An option is a contract representing underlying securities like stocks, currencies, bonds, products, indexes, and futures. These contracts represent 100 shares of the underlying security. A Put option provides the holder the right to offer or sell short a specified quantity of the underlying security at a pre-determined strike price. It is purchased at a premium. The holder is not obligated to sell the underlying security. They are generally utilized for hedging or speculation on downside price action. Options have a particular amount of time, after which they expire. The worth of an option usually decreases as it reaches its expiry. Time decay is the major downside for any options buyer. The risk in option buying is limited to its premium, while the profit potential is unlimited.
Depending upon the option's strike price and the present rate of the underlying security, a put option can be in the money, at the money, or out of the money.
In the Money: The strike price > current price of the underlying
At the Money: The strike price = the current price of the underlying
Out of the Money: The strike price < current price of the underlying
Time value, or extrinsic value, is shown in the premium of the option. Suppose the put option's strike price is $10, and the underlying security is presently trading at $8. In that case, the option has $2 of intrinsic value. The put option might trade for $2.50. The additional $0.50 is the time value, considering that the underlying security's price might change before the choice expires. In money, options have intrinsic value. The buyer can then sell the option for a profit. This is what numerous put buyers do. They can even exercise the option by selling the shares. Out of the Money and at the Money put options have no intrinsic value since there would be no advantage of exercising the option. Suppose the stock is trading at $21 on the stock market. In that case, it is not beneficial for the put option buyer to exercise their option to sell the security at $20. This is since they can sell it for a higher price on the market.
The first factor to think about when buying a put option is volatility. It is one of the main determinants that create the value of any option. When the volatility in the financial markets is very high, there are major swings in the prices. This leads to the great possibility of high fluctuations in the prices of options in either direction. The alternative is not linear. So, the trader ends up getting a gain when the movement is in favor of the trade. But at the same time, they get a loss when the movement goes against them. The second thing is to understand the overall behavior of time value. This is the cost that one pays when buying a put option. The premium has a couple of components. This includes time value and intrinsic value. The strike price of a stock is $60, the spot price is $70, and the premium is $12. Now, out of the overall premium of $12, $10 is the option's intrinsic value, and the remaining $2 is the option's time value. It is very important to find out the difference as the option's time value keeps decreasing when the expiry comes closer and becomes nil. So, it is vital to find how much now one is paying for time value when purchasing an option.
The next tip is to create a great strategy. Traders starting in the financial markets tend to follow a single trading strategy. They either only try to purchase options or write option instruments. But it would boost their trades if they thought it prudent to go with various trading strategies as per the situation in the financial markets. For instance, you may be expecting volatility in the financial markets. Then, you may purchase an option combination such as a strangle or a straddle. On the contrary, you may predict the financial markets to be range-bound. Then you may sell a strangle or a straddle. You can also go through certain strategies, such as Covered Calls and Butterflies, if the market expectations are mildly bearish or bullish.
You should also try to hedge the risk in the trade. Options are quite dynamic and flexible instruments. So, you can utilize them to hedge the risk of your portfolio. For instance, you may be holding a share in your portfolio where you think the prices may come down drastically soon. In this condition, you can hedge on the stock's price by buying a put option. In this manner, hedging can safeguard your capital if there are unpredictable moves in the financial markets. Hedging is the preferred strategy that is utilized by big or institutional investors to safeguard the downside risk to the portfolio. It can also be utilized by retail investors to understand the hedging process and the costs.
The selection of the proper strike prices is also necessary. Often traders go towards buying cheap options with the hope that the shares will increase and generate some good profits. So, they think about purchasing deep out-of-the-money strikes. These are present at a low premium. But the chance of getting that price in the money is very low unless the prices of the stocks get a big swing. When you do not have much time to exercise the rights in trading options, going with at-the-money or just out-of-the-money strikes prices is great. This is because there is a great chance of getting exercised even with a little movement in the prices of the stock. Deep out of the money strikes have a much higher risk of decay in time. This can make the premium of the put option worthless.
Experts have interacted with a lot of retail traders over the years in a lot of capacities. One of the things that they observe regarding retail investors is that they consistently lose money when it comes to buying options. The major reason is that the traders usually move away from trading futures or shares to trading options. So, they started trading option instruments just the way that they were trading stocks. But this is a way to fail. Over the previous year, many retail traders have shifted from trading in futures and shares to purchasing options. This may be because of the leverage rules that are applicable. This trend has also been strengthened by an infusion of more aggressive and younger traders. This has been quite alarming for the experts in the financial markets. They have constantly tried to keep educating the traders on all aspects of trading in options. But there is a lot more that needs to be done. Traders must understand why most of the options buyers lose their money. They should find the best practices that can improve the odds of gains and reduce the risks when purchasing options. The traders should seek out tools and strategies that help them to trade in a better manner.
This is something that a lot of traders realize after spending some time in options trading. Buying more of a share or averaging down if the prices go against the trade is probably the biggest destroyer of the investor's wealth. This process of averaging down may work in some situations. But disaster can strike if something goes wrong with even a single stock. For instance, there have been shares where the prices kept dropping drastically. Many of the retail investors who had bought the shares that the higher prices kept buying more as an attempt to average down. They even sold other stocks to purchase more of those stocks. There was a huge amount of wealth destroyed. But the averaging down can work well sometimes when you purchase stocks, and the financial markets see a rise in the long-term. This happens because the time is in your favor. You may also have the ability to keep on with the position forever. But it is hard to think of doing the same when you purchase options. This is because the times are constantly against you.
The best way to trade in the financial markets is never to get overexposed to any trade that can lead to losing more than five percent of your overall trading capital. If your probable losses are limited, the chances of you acting rationally when a trade goes adverse is a lot higher. The averaging down of positions is done by those traders who do not want to accept the losses they have incurred. This usually happens when the losses are too huge to accept.
The losses are easiest to accept when they are not very big. Because when they do become very big, it gets quite hard to exit the trade. If you place traders in options instruments with more than a single percent of your capital, you should ensure that you have a stop loss in place. Most retail traders get into the vicious cycle of hope and wishful thinking whenever a loss is huge to accept. The intraday or short-term trades turn into long-term positions because of the big losses. When a trader purchases options, the decision to hold on to losing intraday position overnight only increases the losses. When you purchase options, there is a constant loss of time value and the premium. Every extra moment that you hold the buy positions erodes the premium drastically.
Put options provide a technique to offer shares at a set rate, even if the market price drastically reduces. It can give substantial relief to investors. It provides an excellent opportunity for profit generation when you buy a put option.