Buying Puts in a Bear Market
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Dan Passarelli MarketTaker .com |
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With the market starting the week on a sour note, perhaps we should take a look at an option strategy that allows an investor to make a profit from a continued downside move from a stock, index, or ETF - the long put. The long put is a great tool for an investor looking to profit from a downward price move in the underlying stock. Moreover, the long put is a building block on which to build further complex trading strategies like the Married Put, Protective Put, Bear Put Spread, and the Collar. Let's not get ahead of ourselves here; let's start with the basics.
An option player will purchase puts as a directional strategy used for bearish speculation. Our hypothetical option player decides that the recent Dow Jones drop below 10,000 is a signal that a continued downside run has started, so he/she takes a bearish market stance. The put is one of the great aspects of options, you can profit from the downside move of the underlying - you don't have to just hang on and wait for the market to turn around to take a position. For this example, let's take a look at Dow component AT&T (NYSE: T). The stock has flirted with potential support at the 25 level, so our hypothetical investor decides to use this for the transaction's strike price (remember, this is the price at which the contract may be exercised). In order for a put to be profitable at expiration, we will need T to drop below 25.
A nice aspect of the put is that the maximum profit is limited only by the stock falling all the way to 0. However, if an investor has played a front-month 25 put on T, he/she will likely not see the stock fall all the way to 0 before expiration (barring some rather unfortunate news). The investor's maximum loss, however, is limited to the premium paid for the option, a rather nice ratio of maximum loss to potential maximum potential profit. When watching his/her option play, the trader will want the stock to drop past the strike price less the premium paid by expiration. Currently, a February 25 put carries an ask price of 34 cents. Using this price, breakeven for our hypothetical option play is $24.66 cents ($25 less the 34-cent premium).
Let's not get ahead of ourselves here, options aren't foolproof. There are many keys to a profitable option play. The investor needs to understand the technical prospects of a stock. If T was resting on long-term support of some sort (be it a trendline, a moving average, or a price level) north of the strike price ($25) - perhaps a short-term put isn't the answer. This situation calls for a longer-term option, allowing the stock to react to volatility. The passage of time isn't a long option-player's best friend. Also, an investor has to understand the entire situation for the underlying stock and company. Options lose value as time passes, all else held constant. This brings us to another final key for an option play, the investor has to be vigilant and monitor the option. Market timing is key.
Dan Passarelli is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLCTM. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.