Sunday, October 5, 2008

Options: Understanding Puts - making money when a stock price goes down

Stock prices are dropping these days:
You would have to live in a remote village somewhere to not know about the dropping stock market. You hear about how there was over a trillion dollars of value lost from the 778 pont on day drop in the dow this past week. The media focuses on how much money was lost. What they don’t tell you is that many other investors made tons of money that day when prices dropped by using put options and by shorting stocks (see a previous article explaining shorting of stocks).

What is a put option?
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. There are put and call options (I plan to cover call options in a future article). When exercised, put options force the seller of a put to buy stock at a set price.

Using leverage - a put (or call) option controls 100 shares of the underlying stock:
Critical things to know as an investor in options:
1) One put option controls 100 shares of the underlying stock. Therefore, when one put option is exercised by the put buyer, the put seller must buy 100 shares of the underlying stock (an example below will help explain this).
2) Puts (and calls) are priced on a per share basis or 1/100th of the actual cost to buy or sell a put. So, if you see a put trading for $5, it will actually cost $500 to purchase that put option ($5 put option x 100 shares = $500 total cost). These two things can throw new option investors off until they get used to the leveraging inherent with trading options.
3) Put (and call) options on stocks expire at the end of the third week of the associated month. If not traded or exercised by the investor before then, it may expire worthless, or if there is still value in the option - the broker may exercise it automatically. Be careful to know your option’s value on or before expiration day.

How can you make money when the stock price goes down?
As mentioned above, a put option can be exercised to force the seller of the put to buy the underlying stock at a set price from the buyer of the put option if he/she chooses to exercise the option. The desire is to force the put seller to buy 100 shares of a stock from you at a higher price than the current market price you pay to buy the 100 shares to sell.

An example showing how a put option works and the associated leveraging potential:
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.

I do research to find the stock of a company – xyz corporation - with a high probability of going down in price. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November put option with a $45 strike price that expires the third week of November. This put is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the put option.

By November 15th, the price of xyz stock drops to $30 and I tell my broker to exercise the option. I then buy 100 shares of xyz stock on the market for $3,000 ($30 price x 100 shares of stock) and force the put seller to buy these 100 shares at $45 each for a total of $4,500 ($45 x 100). I have just pocketed $4,500 income - $3,000 cost of the stocks = $1,500 from this transaction. However, I paid $200 for the put so my net is $1,500 - $200 = $1,300. This is a 650% return on investment. In reality though the return would be less since there is usually a fee from the broker to buy the put option, buy the 100 shares of stocks, and to sell the 100 shares of stocks.

Another example showing the tremendous leveraging potential in options:
An alternative to exercising the stock purchase would be to sell the put option before it expires to another investor at a profit. If xyz stock is trading at $30 per share on my $45 put option, then there is a $15 profit potential for each of the underlying 100 shares of xyz stock. Keeping in mind the price quoted for a put option is in reference to a single share of stock, then the put should be trading closer to $15 and possibly more if the stock price is continuing to drop. That means I could sell the $2 put for $15 and pocket the difference. In that case, I will have paid $200 to buy the put ($2 put price x 100) and sold the same put now worth $15 for $1,500 ($15 put price x 100) for the same profit of $1,300 ($1,500 - $200). Again, this would be a 650% return on the $200 investment to initially buy the put. In reality, there would be a broker fee to buy the put and again to sell the put. However, you don’t have the extra fees of buying and selling the underlying 100 shares of stocks that would be incurred if the put option was exercised as in the previous example.

What is the potential loss with put options:
The main benefit of using put options to make money on stocks with dropping prices instead of shorting the stock is that your maximum loss of investment is limited to the total purchase paid to buy the put ($200 in the above examples). If the stock price never went lower than $45, then the put would expire worthless and the investor would loose the $200 investment. In the case of shorting a stock, the investor has no limit on the potential loss of the stock price should dramatically increase before the stock can be purchased back to close out the short (again – refer to my previous article on shorting stocks).

The use of put options is making many investor very rich in today’s falling stock market. However, you need to be careful since stock prices can change very quickly in the opposite direction causing your put to expire worthless. Don’t invest too much on puts in any one company. Diversify and use puts as one investment tool among many as part of your investment strategy.

Your feedback is wanted:
Please provide feedback to our generic email at on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: Key past articles related to investments in oil and gas can be found at This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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