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Options Trading -- Five Benefits to Trading in Puts

By  Aug 5, 2010

Topics: Finance & Investing

The “put” option, unlike the better-known call, is often overlooked as a strategic weapon. Because markets move in both directions, the ever-optimistic American trader can easily forget that it goes down at times, and not only up. This is where the put -- like a shy teenage girl at her first dance -- is easily overlooked or taken for granted.

Five important attributes of puts may change how you look at this option:

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.

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 options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press books are Put Option Strategies for Smarter Trading and Trading with Candlesticks.