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Options Trading -- Don't Forget about the Value of Puts

Posted September 8, 2011

Topics: Finance & Investing

The put option is easily overlooked as a strategic advantage. Because markets move in both directions, the optimistic American trader can easily forget that markets go down at times, and not always up. This is where the put is easily overlooked or taken for granted.

Five important features of puts may change how you look at them:

1. Markets can -- and do -- move downward. Those traders who like long calls always think the stock’s price is going to rise. But what if it falls? The put will grow in value when the underlying stock’s price goes down instead of up. Because this is more likely after a price run-up, reversal in price trends in the short-term make put buying a smart offset strategy to accompany call buying.

2. Puts are valuable for insuring paper profits. Imagine the dilemma when you buy stock and its price rises. Do you take profits now or just hold on to shares? If you don’t want to sell, it makes no sense to sell just to take profits. An alternative is the insurance put -- buy puts as a form of insurance in the event the price does reverse. The put’s intrinsic value rises for each point the stock drops, and it can be closed to take the profits while letting you keep your stock. Another way to use long puts is as part of a collar (100 shares, one long put and one short call).

3. Puts are good tools in straddles and spreads. In advanced option strategies, you do not have to limit yourself to long and short calls, or to varying expiration dates. Using puts along with calls (long, short, or both) opens up the possibilities and greatly expands the possible strategies you can employ in your trading program.

4. Selling naked puts is less risky than selling naked calls. The potential risk to the naked call can be very high; but the naked put is not as risky, especially for lower-priced stocks. Some people think the maximum risk is the difference between the put’s strike price and zero, but it is not even that severe. The real potential loss is the difference between the strike price and tangible book value per share, minus the premium you get for selling the put. Given the time decay in the put, chances of loss are much smaller than many traders think.

5. Puts round out a day trading or swing trading strategy. If you use only long calls or shares of stock for short-term trading strategies, you severely limit your potential. You can only enter a position at the bottom of the swing; otherwise you have to use short calls or short stock on the top. Puts solve this problem. You can buy long puts to take advantage of downward swings without adding the risk of going short. This makes the put an elegant solution to any trader who wants to avoid short selling risks.

Puts should not be overlooked as part of your trading strategy. They not only offset calls and even enhance advanced strategies. Properly applied, puts can also reduce exposure to market risk.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to several blogs: CBOE, Seeking Alpha and the Global Risk Community.