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Options Trading: The Overlooked Put

Posted March 17, 2011

Topics: Finance & Investing

The put, that bearish instrument not as well-liked as the call, deserves equal consideration. Why? Because markets are volatile and can either rise or fall. Puts enable traders to profit in down markets, but without the risks of shorting stock. Used together, puts and calls can be structured to create some very interesting and potentially very profitable options strategies.

With calls alone, you are limited to two general selections: Either speculate and hope you are one of the 25% of long option buyers who even realize a profit, or write covered calls. The covered call is an excellent profit generator and a highly conservative strategy. But it is not the last work on smart option trading.

Some interesting strategies involving puts:

            1. Expanded covered call writing to create a collar. Some traders fear covered call writing, knowing that if the price of stock falls, the put is profitable but the stock loses value. Of course, the loss is not as bad as it is when you just hold shares of stock. Even so, the danger of loss from a falling market is completely eliminated when you convert a covered call into a collar. This is a position with three parts: 100 shares of stock, a covered call, and a long put. The cost of the put is paid for by income from the call. If the price of stock rises, the covered call might be exercised (or it can be closed or rolled forward). This is a risk covered call writers know well. But if the stock falls, the put will increase one dollar in value for every dollar the stock loses below the put’s strike. The put’s cost is paid by the short call, so the downside protection is free.

            2. Synthetic stock positions. These are among the most interesting of all options strategies. Synthetic long stock is a combination of one long call and one short put, opened at the same strike and with the same expiration. For every movement in the stock’s price, the overall value of the options moves too, and to the same degree as the stock, but for little or no cost. The cost of the call is paid for by income from the put. The opposite, synthetic short stock, involves one long put and one short call. As risky as a short call sounds, if you also own 100 shares, the call is covered and synthetic short stock acts just like the collar.

            3. Puts for playing bear markets in a swing trading strategy. Traders often act as day traders or swing traders, moving rapidly in and out of positions to play short-term over-reaction to news. Several problems with swing trading include having to contend with a limited capital base, and the risks of shorting stock. Consequently, many swing traders only play the uptrend side of the swing. But with long puts, you can play both sides for very little risk. Shorting stock is never necessary, and using options allows for greater leverage and diversification.

Some optimism about puts is well founded. They expand the possibilities in many ways.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” 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 the CBOE newly-formed blog.