Order Entry: Debit
Ideal Environment: Low IV
Profit Target: Arbitrary (no ideal %)
Definition: An agreement that gives the buyer of the option the right (but not the obligation) to sell a stock at a specified price and quantity on or before a particular date.
Each stock option covers 100 shares of the underlying stock.
Buying Put Options
The holder of a put option has the right (not the obligation) to sell an agreed quantity of stock to the seller of the option within a fixed period of time (until the expiration date) for a certain price (strike price).
The risk of buying put options is having the options expire worthless by the expiration date. The max loss for buying options is the premium paid to the seller of the put option.
As a buyer of the option, the trader can sell the option before the expiration date. The buyer of the put is allowed to sell the put option at a higher price for a smaller profit without having to actually sell stock.
A disadvantage of buying options is negative theta decay (time value). As the option approaches expiration the time value portion of the option decreases. This is bad for the buyer of the option because if the stock does not move, the option still loses value up until expiration.
Buying OTM puts has a lower probability of success, but the ROI is higher. Buying ITM puts has a higher probability of success, but the ROI is lower. Basically, you get paid more when taking on more risk.
In order to breakeven during the purchase of an OTM put option, the price of a stock has to depreciate past the put strike price before expiration.
Breakeven = Put Strike Price - Premium Paid - Commissions
Every penny below the breakeven price is pure profit. Profit is the difference between the stock price and the breakeven point multiplied by 100 shares/contract.
Profit = (Breakeven – Stock Price) X 100 shares/contract
Even though a stock goes down and gets below the strike price, the trade may still result in a loss. This is due to the negative theta decay. The positive difference between the stock price and put strike price doesn’t outweigh the premium paid.
Partial Loss = ((Strike Price – Stock Price) X 100 shares/contract) – Premium Paid
If the stock price stays the same or goes up the option expires worthless and the trader loses the premium paid.
Max Loss = Premium Paid