Online Trading Concepts

Downside of Buying Put Options

Put Options

  1. Buying Put Options
  2. Put Option Profit, Loss, Breakeven
  3. Downside of Buying Put Options

Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.

put option profit and loss graph

Put Options need Big Moves to be Profitable

Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:

If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:

If the stock moves down 5% in the following 30 days:

If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:

It's fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader's call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.

Capital Preservation

Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.

Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:

For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:

In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.

Moral of the story

Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:

  1. The direction the stock will move.
  2. How much the stock will move
  3. The time frame the stock will make its move