Strategy in brief: Buy a put option and benefit from the stock price downturn.
When to use this strategy: you are very bearish on the stock.
Comments:
· The more bearish you are, the more out-of-the-money (lower strike) your option should be.
· No other position gives you as much leveraged advantage in a falling stock (with a limited upside risk).
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Figure: Buy Put Strategy Example
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Profit: increases as the stock falls. At expiration, break-even point will be the strike less the premium paid. For each point below break-even, profit increases by an additional point.
Loss: limited to the premium paid for the option. Maximum loss is realized if the stock ends above the strike. For each point below the strike, loss decreases by an additional point.
Risk: Limited.
Reward: Limited.
Margin: Not required.
Time decay: This position is a wasting asset. As time passes, value of position erodes towards the expiration value. If volatility increases, decay slows; if volatility decreases, decay speeds up.
Research Findings and Trading Tips:
1. In comparison with a short sale of the underlying stock, this strategy offers much higher return with a limited risk. However, these advantages are balanced by a couple of shortcomings.
2. Out-the-money puts are cheaper and offer higher returns and risks than in-the-money puts. However, they contain only time value. That is why in-the-money puts are considered a better choice for momentum players.
3. When the underlying stock moves much lower and the option holder gets an unrealized profit, the following “roll down” tactic has become popular: you sell the put option, return the initial investment and use the remaining proceeds to buy as many puts with lower strikes as possible.
