Buying Puts

Buying puts is a bearish options trading strategy and is also referred to as “buying in-the-money puts.” It is a somewhat speculative technique in which the investor anticipates that a stock will decrease in price during a specific period of time. The trader realizes a profit when the stock and its underlying put option decrease in price during a set amount of time. The profit potential is limited because a stock price can never go below zero. When buying puts, if the price of the stock remains steady or rises during the option period, it is possible for the trader to lose the initial investment. This risk is however limited to the amount paid for the premium on the put option.

Buying puts is dependent on the timing and the charting of a stock’s movement to catch a downward price movement. Accurate charting of a stock and the technical analysis of its performance, as well as direction are critical when buying puts. There are a variety of events that can move the price of a stock down as desired, such as poor earnings reports, buyout or acquisition of the company, and new product introduction. These types of events can shape the views of investors and impact the stock market. This strategy of buying puts can also put more money in the pockets of successful traders.

The downside of buying puts tends to be the possibility of an error of judgment. If an investor decides to buy puts on a stock without properly researching its position or charting its movement, it is possible that the stock will be bullish or that it will change from bearish to bullish. In essence, if a stock reaches its bottom or is rising, the trader may move at the wrong time and is in danger of losing the premium for the trade.

Buying puts is actually an alternative to selling short on a stock. While it is similar to buying calls, the advantage of buying puts over selling short lies in the ability to leverage the transaction and make your trading more successful. Since the puts can be purchased on the margin, it is possible to control a much larger number of shares, thereby increasing the profit potential on the purchase. Downward movements in stock prices and their underlying put options create much larger returns than by simply selling short.

The price of a premium for buying puts is affected by two variables. First, the time period involved for the option is a determining factor in price. The longer the time between purchase and expiration dates, the higher the price. Second, the movement of the underlying stock affects the price of the premium, especially in relation to the stock’s strike price. A stock that has been in a bearish trend will have a higher premium than a stock in a bullish trend.

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