Buying a Put Option

If you believe that a certain commodity will be DECREASING in price within a SPECIFIC period of time, then you should consider buying a put option.

Just as with call options, if the events prove you wrong, and the price of the underlying commodity moves in the opposite direction, or doesn’t move at all, the maximum you’ll lose is the premium you paid for the option, plus commissions and transaction costs. On the other hand, if the events prove you right, you stand to make unlimited profits.

The primary difference between the put option and the call option, is that with the put option your outlook on the market is bearish. While with the call option your outview is bullish. In effect, with put options we want the price of the commodity to drop.

BUYING A PUT OPTION
As the price of the underlying commodity decreases,
the value of the put option increases

 

Before buying the put option, you’ll need to make the same type of considerations as you made with the call option. That is, what is the length of the option you’re trading? And what is your break-even point? 

 Remember, the greater the length of the option, the better the chances of the option becoming profitable. In the case of a put, the option becomes profitable as the commodity decreases in price.  Here again though, length has an impact on how much you’re going to pay for that option. A longer option will cost more. And the more you pay for the option the greater your break-even point.

A put option is a mirror image of a call option. Everything is just reversed. So when figuring your break-even point for a put option, instead of adding the premium to the strike price, you’re  going to subtract them.

PUT BUYING BREAK-EVEN POINT

Break-even price   =   Strike price  Premium Commissions & Transactions  
 

Example: You buy a wheat put option with a strike price of 350 (Represents $3.50 a bushel. Wheat trades in bushels per cent, so it’s often just abbreviated in the financial newspapers as 350)

You pay a premium of $400, plus $50 for commission and transaction costs. The current market price of wheat contracts is $3.50 a bushel. Based on these figures, your break-even price is $3.41 a bushel. Here’s the math:            

1st)  Strike price $3.50 

2nd) Find out what the $400 premium translates into at cents per bushel. Wheat trades
       in 5,000 bushels so:  $400 / 5,000 bu =  0.08 = 8 cents

3rd)  Find out what the $50 commission and transaction costs translate into at cents
        per bushel: $50 / 5,000 bu = 0.01 = 1 cent

4th)  Break-even = $3.50 - .08 - .01 = $3.41

Just as we’ve done with call options, let’s look at some examples of buying put options in the money, at the money and out of the money.
 

Examples:

We’re in the month of March, and you’re considering buying a 390 Gold June put option. Gold is currently trading at $390 an ounce (COMEX Gold trades in 100 troy ounce contracts in dollars per ounce) You’re bearish on gold, and believe the price of gold is going to drop between March and the actual option expiration date in May (Your broker should provide you with exact May expiration date).

This put option will give you the right (but not the obligation) to sell a specified 100-ounce gold futures contract at the strike price of $390 an ounce, anytime before expiration of the option. You pay a premium of $450 for it.  In other words, $4.50 an ounce ($450/100 ounces = 4.50). Plus $100 commission and transaction costs, which translate into $1 an ounce. Your break-even price, therefore, is $384.50. When gold goes down to that price, you can recover all your costs. Anything lower is net profit.

At this time, this put option is at the money. It has no intrinsic value.

Now it’s the month of April, and the price of gold has indeed fallen. The current market price is $384.50 an ounce. The option is now in the money  and has some intrinsic value built-up. If you would decide to sell the option back and close the transaction, you would break even. So at this junction, here are the possibilities:
 

a)  The price of gold keeps going down and you offset your option before the expiration
     date and make a profit.

b)  The price remains pretty much the same and you break even.

c)  The price suddenly turns in the other direction, so you offset your option before the  
     expiration 
date and incur a partial loss.

d)  The price suddenly turns in the other direction, the option expires and you lose it all.


Faced with these possibilities, let’s follow through:

a) Before expiration, the price of gold drops to $360 an ounce. You sell the option at
    the strike price of $390 an ounce in the open market as part
of a closing transaction,
    realizing a profit of $2,450, minus $550 for all your costs.

b) The price of gold holds steady at $384.50 on ounce up to expiration date. You liquidate
    the option at the strike price of $390 an ounce and make a profit of $550. When you
    minus the $450 premium and the $100 commission and transactions costs, you break
    even.

c) Instead of falling, the price of gold rises from $384.50, to $388. You’re worried it’s
    getting too close to expiration, and there won’t be time left for the option to become
    profitable, so you decide to limit your losses by selling the option back at $390. You
    have a $350 loss.

d) Same scenario as in c), only this time you hold onto the option all the way to the end,
    hoping for a reversal of fortune. Instead, the price climbs to 395 an ounce. Your option
    is now out of the money with no time left. It expires, and you lose $550.


As the price of the underlying commodity – in this case the 100-ounce June gold contract rose, the put
option lost all and any of its intrinsic value. Likewise, as it was getting near the expiration date, it was losing its time value.

A graphical representation follows:

putoption-graphThe a) line is our option gaining value by decreasing to 360. The d) line is our option losing value by increasing to 395. In the middle, is our strike price at 390. We figured our break-even point to be at 384.50.

Let’s continue with our example:

It’s the month of March, and the price of gold has been sliding for weeks. The market price of a 100-ounce gold contract is currently 370 an ounce. You feel the trend will continue, so you want to buy a short expiration option that’s already in the money, and decide on a 390 May gold put option, giving you the right to sell a 100-ounce May gold contract at $390 before expiration sometime in April. It has a built-up intrinsic value of $20 an ounce. But don’t get too excited just yet, because as you know, nothing’s for free. The premium on this option will cost you $2,500 or $25.00 an ounce ($2,500 / 100 ounces = $25.00) Plus $100 for commission and transaction costs (that’s $1 an ounce). Therefore, your break-even point is $364 an ounce. The price of gold is going to have to drop at least $6 an ounce over the next month, just for you to break even.

          In just a matter of a week, the price of gold falls to $360 an ounce. Since you’re a disciplined trader with established profit objectives, you sell the option back and take a $400 profit ($364 – $360 = $4; and $4.00 x 100 ounces = $400). You made this $400 in just one week because you entered and exited the market at the right time. You didn’t deviate from your plan and avoided getting too greedy. You also recognized that a small but quick gain, is just as valuable as a larger gain that may be spread out over a longer period of time.

Now let’s change the setting just a little. This time you want a cheaper option. We’re in the month of March, and you feel the price of gold is going to come down, but you’re unsure as to how long it will take. Therefore, you buy an out of the money 360 August Gold put option. The market price of gold is currently 375 an ounce. You’re $15 an ounce out of the money. You pay your premium of $160 (that’s $1.60 per ounce) and commission and transaction costs of $90 (that’s 90 cents an ounce). Based on this, your break-even price is $357.50 an ounce ($360 – $1.60 – .90 = $357.50). Gold will have to drop $17.50 by July, for you just to break even.

Within only two weeks, the price of gold collapses to a year low of $355 an ounce. If you sell back your option now, you’ll end up with a net profit of $250 (break-even price of $357.50 – $355 = $2.50, and $2.50 x 100 ounces = $250). That’s a 100% return on your investment.

But since you haven’t established exact profit objectives, you refuse to exit, and decide instead to ride the option a little while longer. However, after some price oscillations, gold climbs back to $375 and settles. Your option expires and you lose $250 (premium and commissions).

On the one hand, you can view this lost as simply a bad decision on your part. Even though at one point  your returns were 100%, your lack of clear profit goals obscured your better judgment as to when to exit the market. You not only lost your costs, but also the opportunity to double your money.

Alternatively, since a put option (just as the call option) limits your risk to just the up-front costs of the option, while offering you the opportunity of unlimited gains, you could say it wasn’t a bad gamble. After all, you risked a relatively small amount of money.
 

Advantages And Disadvantages Of Buying Put Options

Once again, the plain fact here is that time works against all option buyers (puts and calls). As you get near the expiration date, your put option has a declining time value, and when it expires it becomes worthless. 

In our examples, we’ve selected an in the money high-priced put, very close to expiration, but where we stood to lose a lot more money if the underlying commodity moved in the wrong direction. In contrast, we’ve seen the purchase of an out of the money low-priced put, farther away form expiration. In this case our capital commitment was much lower, but we needed many points of price movement for a profit.

So it should be clear by now, that the further out of the money a commodity is, the cheaper the premium for a put (or a call), and the lower the chance for profit. And the further in the money a commodity is, the more expensive the put (or the call), because of its intrinsic value. In the same manner, an in the money or an out of the money put (or call) will command a higher premium the farther away it is from expiration.

It should also be pretty clear by now, that’s its important to enter any trade with clear and concise profit objectives. You should have a pre-defined plan as to when to exit the trade. This will help you immensely. One can argue that if you’re going to lose, it’s better to lose at least by sticking to the plan than by being side-blinded.

ADVANTAGES :

  • Limited risk – If the price of the commodity rises, you’re total possible loss is the purchase price of the put option plus commissions and transaction costs.
     
  • Small capital commitment -The cost of buying a put option is substantially lower compared to the cost of a futures contract (or most any other asset.)
     
  • Unlimited profit potential – Even though your risk is pre-defined, your potential for profits are absolutely unlimited.
     

DISADVANTAGES:

  •  Lower probabilities – It’s difficult to consistently guess correctly the timely price direction of the market.


So why do people buy put options? Just as with call options, while the odds work against you, it’s possible that with a few profitable options you can more than make up for losses incurred with the others.

Also, for many people who hold positions in futures contracts (or own shares of stock for that manner), the risk of decline in price is constantly a concern. For protection against such a price decline, buying a put option would act as an insurance policy. This is known as a hedge strategy Some investors might even purchase 1 put option for every contract they own. This is known as a downside protection.4  If the value of your futures contract declines, you would exercise the put and sell the futures contract through exercise.


4 In the stock market world it’s 1 put for every 100 shares owned.

 

Next: Go to Selling a Call Option