Buying Puts - Bearish Options Trading Strategy
Buying puts is a bearish, somewhat speculative technique in which the investor anticipates that a stock will decrease in price during a set 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 in such a deal is limited because a stock price can never go below zero. Also known by the term “buying in-the-money puts”, this technique is speculative; 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 reward ratios, however, are limited to the amount paid for the premium on the put option.
The technique of buying puts is dependent on timing and charting a stock’s movement to catch a downward price movement. Accurate charting of a stock and technical analysis of its performance and 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 are among the events that 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 this technique 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 stock will be bullish or changing from bearish to bullish. In essence, if a stock reached its bottom or is rising, the trader has moved at the wrong time and is in danger of losing the premium for the trade. Investing mistakes such as this are a prime example of what can go wrong when buying puts.
Buying puts is actually an alternative to selling short on a stock. While being 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. This is a stock market basic that can be successful even for a beginner investing in the stock market.
Buying puts is one of the stock option trading strategies that provides the investor with the opportunity to make money on a stock expected to be bullish. Remembering to follow a proven stock market trading system will help deter the trader from moving on the wrong stock.