by Wendy Kirkland

Put options have a legitimate place in trading (they really do!), but the concept goes against what you may have been taught by the wisest of teachers in your life. Specifically, were you taught that paying for something that may go down in value could be a very wise investment?

Put Options are contracts that give the owner the right, but not the obligation, to sell a specified number of shares of a stock at a specified price (strike price) on or before the specified date (expiration date).

You’ll purchase Put options when the price of the underlying stock is expected to go down. This is also considered a short position because it benefits from a decline in the equity’s price.

Why would you consider purchasing something you expect to decrease in value?

Let’s use an example to explain the concept in simple terms: You and your neighbor, let’s call him Jim, are standing on your driveway discussing the new outlet mall under construction about a half mile away. You both agree that the new shopping area will be convenient and will add value to your already appreciating property.

A real estate agent walks up to you, while you’re telling Jim about the proposed golf store that will be at the mall. He explains that he’s selling formal papers that guarantee that if you decide to sell your home anytime over the next year he will pay $120,000 for the house, no more, no less, but the $120,000 is guaranteed. This guarantee will cost $2,000.

Jim is insulted. “Why the heck would I consider paying $2,000 to let you buy my property for $120,000? It’s worth $115,000 now and it’s been appreciating 10% every year for several years. With the new shopping center coming in, who knows? By the time that contract runs out, you’ve been thinking about moving, but haven’t found a new house yet. You know your house might go up in value before you actually want to sell, but this guarantee feels like insurance. You tell the agent to get the paperwork ready while you get your checkbook. So, you pay the real estate agent $2,000 for the paper guarantee.

Three months later, you find the perfect house across town, and quickly find a buyer willing to pay $125,000 for your old house. Of course, now you feel a little foolish for purchasing the contract to sell at the lower fixed price. And ol’ Jim rubs it in – even to the point of being mean about your “silly” mistake. Nevertheless, you hang on to the contract.

Seven months later, a 6:00 o’clock newscast reports that many years ago, toxic waste material was buried beneath the ground in your old neighborhood. This news has an immediate effect on the housing market in your town. Within days, you learn that the house your recently sold is now worth only $60,000. At that point, you remember the paper you hold, guaranteeing a price of $120,000.

You consider going to your neighbor Jim, but his mean attitude has stuck in your craw. Instead, you go the young family who purchased your home. “I had no way of knowing: I’m sorry this happened to you”, you say. “I didn’t have a clue about the toxic waste. But, I have this paper and I’m willing to sell it to you for $4,000. The paper says that a particular real estate agent is obligated to purchase the house for $120,000.”

Naturally, the young family is ecstatic. They will be out from under the poor investment at a loss of only $9,000: the extra $5,000 they paid you for the house, plus the $4,000 for the paper guarantee. You’re happy to have sold the house and the paper.

On the other hand, Jim sits in a house that’s depreciating daily and will continue to do so until the toxic waste cleanup can be completed – and who knows how long it will be before people forget about the bad association with the neighborhood.

But, in the ten months since you purchased that contract, you doubled the $2,000 you paid for it, so you have 100% profit.

In my example, I point out that no one could have anticipated the toxic waste situation, but that might not be entirely true with a Put purchase. You purchase Puts with the same care and consideration that you would put into your Call choices. You are drawn to a security by its chart and then you do your homework. You know its past earnings history, its next earnings report date, what sector it’s included in and whether that sector is in favor at the moment or cycling out. In addition, you look up current news articles and analysts’ opinions and know whether it has been recently downgraded. Guided by the security’s chart, you can see that it often telegraphs its fall from grace.

The Principle Behind Puts

If or when you own the underlying equity, Puts can be purchased as insurance against a stock going down in value.

In the example I’ve covered, you don’t own the underlying equity, just as you don’t own the stock in the companies or other equities upon which you purchase Call options. However, during your chart reading, you see a situation developing that indicates that a stock, index, or ETF might be cycling down; or, perhaps it’s confronting other bad news, such as a poor earnings report, bad PR, losing a contract, or FDA refusing approval for a product. You can purchase a Put, knowing that when the equity goes down your contract to “sell” shares at that higher fixed price will go up in value. The farther the shares drop, the more valuable your contract becomes. Then, when your chart reading indicates that the equity has hit bottom, you sell your Put contract, before expiration and before the shares start to regain their value.

When you sell your Put to close your option, the stock exchanges have buyers anxious to snap it up, so they can sell their stock at its former higher price, rather than wait the time necessary for it to eventually regain its value.

As you scan through your charts, opportunities to purchase Puts are the opposite of Calls. These opportunities arise when an equity is at a high point and your indicators show that the trend is about to reverse, that is, headed downward. You identify many of these occasions when the MACD, PPO, ADX cross downward, becoming negative, or when the Williams %R or RSI are dropping out from being overbought.

The same indicators can point out the time to sell a Call that you own. So, just as indicators can suggest the opportunity to purchase a Call, they can also indicate that it is time to sell a Put that you own.

In actual trading situations, many traders who have purchased Calls on an up-trending stock which has climbed upward over a period of months will then purchase Puts on the very same stock, riding it through the downtrend.

Stocks cycle up and down. Over the course of a year some stocks may gain 20-30% in value, yet they moved up and down, retracing that 20-30% many times. Alert option buyers can take advantage of those swings in trend.