Buying Lead Put Options to Profit from a Fall in Lead Prices

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Put Option

What is a Put Option?

A put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price Strike Price The strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on whether they hold a call option or put option. An option is a contract with the right to exercise the contract at a specific price, which is known as the strike price. ) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option Call Option A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price – the strike price of the option – within a specified time frame. . Put options are traded on various underlying assets such as stocks, currencies, and commodities. They protect against the decline in the price of such assets below a specific price.

With stocks, each put contract represents 100 shares of the underlying security. Investors do not need to own the underlying asset for them to purchase or sell puts. The buyer of the put has the right, but not the obligation, to sell the asset at a specified price, within a specified time frame.

The seller has the obligation to purchase the asset at the strike/offer price if the option owner exercises their put option.

Buying a Put Option

Investors buy put options as a type of insurance to protect other investments. They may buy enough puts to cover their holdings of the underlying asset. Then, if there is a depreciation Depreciation Methods The most common types of depreciation methods include straight-line, double declining balance, units of production, and sum of years digits. There are various formulas for calculating depreciation of an asset. Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. in the price of the underlying asset, the investor can sell their holdings at the strike price. Put buyers make a profit by essentially holding a short-selling position.

The owner of a put option profits when the stock price declines below the strike price before the expiration period. The put buyer can exercise the option at the strike price within the specified expiration period. They exercise their option by selling the underlying stock to the put seller at the specified strike price. This means that the buyer will sell the stock at an above-the-market price, which earns the buyer a profit.

Example

Assume that the stock of ABC Company is currently trading at $50. Put contracts with a strike price of $50 are being sold at $3 and have an expiry period of six months. In total, one put costs $300 (since one put represents 100 shares of ABC Company). Assume that John buys one put option at $300 for 100 shares of the company, with the expectation that the ABC’s stock price will decline. The stock price is expected to fall to $40 by the time the (put) option expires.

If the price does drop to $40, John can exercise his put option to sell the stock at $50 and earn 100 shares times $10 – $1,000. His net profit is $700 ($1000 – $300 option price]. However, if the stock price remains above the strike price, the (put) option will expire worthless. John’s loss from the investment will be capped at the price paid for the put.

Selling a Put Option

Instead of buying options, investors can also engage in the business of selling the options for a profit. Put sellers sell options with the hope that they lose value so that they can benefit from the premiums received for the option. Once puts have been sold to a buyer, the seller has the obligation to buy the underlying stock or asset at the strike price if the option is exercised. The stock price must remain the same or increase above the strike price for the put seller to make a profit.

If the price of the underlying stock falls below the strike price before the expiration date, the buyer stands to make a profit on the sale. The buyer has the right to sell the puts, while the seller has the obligation and must buy the puts at the specified strike price. However, if the puts remain at the same price or above the strike price, the buyer stands to make a loss.

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What is a put option? A put option gives the purchaser the right but not the obligation to sell 100 shares of the underlying stock for a set price, the strike price of the option. This is true except at expiration, when a “long-in-the-money put option” is automatically exercised by the Options Clearing Corporation unless you instruct your broker not to exercise it.

The basic definition or characteristic of put options is that they increase in value when the underlying stock decreases in price. So option pricing on put options will increase when a stock declines. Two common options trading strategies include purchasing the put option to attempt to profit from a stock declining or using it as a synthetic stop loss to protect the shares of stock you own against the price going down.

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Some options can’t be settled with the sale of the underlying like an index (you can’t buy an index!), in which case the option would be settled in cash and is referred to as an index cash settled option. Put options are limited by time of course, meaning that they have an expiration date associated with them, as do all options.

Let’s look a little deeper at how a put option can act like insurance for the stocks that you own:

Say you own 100 shares of IBM which is trading at 100. IBM is coming out with earnings in a few days and you are concerned about your position if earnings are bad. However, you don’t want to sell your shares at this point in time. So you decide to protect your shares by purchasing the IBM 100 strike put option that expires in 30 days for $1 or $100 ($1 x 100).

This is like buying and insurance policy for 30 days.

Purchasing this put option gives you the right to sell your stock for $100 no matter how much it falls. If earnings come out, and IBM goes up, you make money on the stock, but lose some of the options premium you paid for the put you bought. It is like you bought car insurance, but you never got into an accident. So you lose the price you paid for the insurance. Unlike insurance policies though, if earnings came out and you still had 29 days to expiration, your put option might still have some value allowing you to sell your put and close out the position.

Now let’s say that IBM comes out with poor earnings and drops to $90. If you had done nothing, you would have a paper loss of $10 x 100 shares, or a $1000 loss. Instead you have a couple of choices at this point because of your purchase of the put option as protection:

1) You can exercise your option to sell or “put” the stock to someone for the strike price of $100. If you do that, your loss would be $100, or the cost of the put.
2) You could sell your puts which have now gone up in value and are now profitable in-the-money options. After the decline their value will be approximately $10 in value. If you sell the put your profit is $1000 minus $100 paid = $900. In this case, remember, you still own the stock.
There are many reasons why you might choose one or the other based on tax issues, future directional opinions as to where you believe IBM is going etc., etc. But for now, the put option did its job of acting as an insurance policy for your shares.

Our second trade scenario is to use put options is as a speculative trade, believing that a stock might be going down. There is no need to short the stock and worry about unlimited risks associated with that or the high margin requirements. If you buy a put you have a fixed cost and earn money if you are correct and the asset goes down (in very simple terms).

Time value, magnitude of the move, and volatility all have an impact on the option price, but for now let’s keep the example simple and not focus on those other variables. You don’t own IBM but you think that earnings are going to be weak so you invest $100 with the assumption that IBM will decline and thus profit from the increased value of the put you purchased, again ignoring time decay and volatility.

A quick review if you are a new options trader: the very definition of put options is that as the underlying security decreases in price, the value of a put option will increase, time decay and volatility not-withstanding. This is one key options trading strategy to consider if your analysis concludes there is more supply than demand and you believe it will result in a price decline in a certain amount of time.

As with call options, you can buy puts on many different asset classes including stocks, ETFs, indices, futures, and commodities. Put options can be a great way to protect a position you have in your portfolio to help get mitigate risk and/or lock in most of your profits without having to sell your shares. Puts also provide a way to play the downside of the market without having to initiate a short-sale position and experience the unlimited risk and margin requirements of short-stock positions.

Short selling versus put options: a guide for investors

Short selling and buying put options can be used to profit from falling share prices. But what differentiates the two approaches and how do they stack up against each other?

Put options

With options, we pay a non-refundable sum of money, known as a contract premium, to gain the chance to profit from a move in an underlying security price.

Buying a call option allows us to profit from upward moves in shares, whereas buying a put option enables us to profit from down moves.

Buying a put option, otherwise known as taking a ‘long-put’ position, provides us with the opportunity to theoretically sell an underlying share at a predetermined price and by a certain date.

In practice, when an option contract position has gone our way, we should be able to simply close the position with one click on our laptop to realise profits.

When we purchase a put option, our maximum loss is always limited to the contract premium.

Profiting from puts

For example, suppose the shares of DriverlessCar Company are trading at $160, as at 1 May. A put option contract with a strike price of $150 expiring in a month from now is priced at $3.

We expect the stock price to fall over the coming weeks; we pay $3,000 to acquire put options covering 1000 shares.

Fortunately for us, at option expiry the share price has fallen to $140. Our put options are now ‘in the money’ with a total intrinsic value of $10,000 and we can now sell them for that amount.

In this simplistic example, the intrinsic value of our put options is equal to the difference between the strike price and the option price at expiry multiplied by the number of shares being covered by the contracts.

As we paid $3,000 to buy the put options, our profit from the position is $7,000:

Profit= $10,000 intrinsic value – $3,000 contract premium = $7,000

Limited risk

While put options can offer attractive returns, the downside is limited. Suppose the share price of DriverlessCar remains in a fairly narrow range before rising sharply at contract expiry to $185 after the company reports strong results from new product launches.

In this case, the put option was unprofitable, or in other words remaining ‘out of the money’.

On the bright side, even though the shares rose sharply before our option contracts expired, our loss is still limited to the $3,000 in premiums we paid at initiation on 1 May. The profit potential on a long put is also limited as a share cannot fall below zero.

While long puts can be used for speculative reasons, they are well suited for hedging the risk of a decline in the conventional portfolios and shares that we hold.

Consider the situation of a fund manager who is compelled by their mandate to always hold a certain percentage of a portfolio in equites during all market conditions, including bear markets.

Gains from long-put positions can be a welcome relief, offsetting at least some of the losses from conventional shareholdings.

At other times, rises in the value of our traditional holdings can easily counterbalance the contract premiums paid for our put options.

Low probability

It may all sound too good to be true, but the probability of an option contract being ‘in the money’ and providing us with a profit in its own right is typically only 25%.

The probability is a function of the volatility of the option and the length of the contract; the higher both these factors are, the more likely it is that the strike price on the long-put contract will be reached.

When it comes to options, volatility could be thought of as our friend – higher share price volatility increases our chances of making a profit. In a low volatility situation, when an underlying share price remains virtually unchanged, we´ve still lost the option premium that we paid at the initiation of the contract.

However, the cost of contracts on stocks with higher volatility will also be greater, reducing our potential for profit.

Buying contracts on stocks with lower volatility, but which we believe hold strong potential for share price movement due to events, can prove to be better value.

Some stocks are a lot more volatile than others, with ‘beta’ commonly used as a measure of share price volatility.

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For instance, a share with a beta of 0.9 could be thought of as being 10% less volatile than the market average. A share with a beta of 1.2 is theoretically 20% more volatile than the market.

Short selling

Like long puts, short selling enables us to profit from downward movements in share prices. As with puts, the potential gains are limited because a share price cannot fall below zero.

However, unlike using puts, the potential losses from short selling are theoretically unlimited.

To initiate a short-selling trade, we must borrow shares and then sell them in the market. If the share price drops as we hope, we can then buy them back at a lower price.

This price difference forms the basis of our profit from the trade. However, if the share price rises sharply, we are fully exposed to the resulting losses.

If the price does rise significantly, we could be compelled to provide additional margin (the money a broker requires as security for a trade) in addition to the initial margin we would have had to post at the outset of the trade.

Margin of error

One advantage of put options is that there is no such margin (borrowing) requirement involved. Typically, 50% of the total sale amount must be posted as margin at initiation of a short-selling trade.

This equates to $80,000 if we had sold short 1,000 shares in DriverlessCar Company when the share price was at $160 on 1 May.

If the share price had fallen to $140 as in the earlier example, our potential profit from short selling would have been:

($160 – $140) x 1,000 = $20,000

If the shares had subsequently risen to $185, our paper loss from short selling would have been:

($185 – $160) x 1,000 = $25,000

In this scenario, the put option contracts appear much more favourable as our losses were limited to $3,000.

Short selling entails less risk when the security being shorted is a market index or an exchange-traded fund (ETF). This is because individual shares carry much more potential for sharper movements.

Regulations have been imposed in recent years to make short selling more transparent. Some of the larger short-sale positions of financial institutions can be viewed on regulators´ websites.

*excludes cost of borrowing stock short or any interest payable on margin account.

Time advantage

On the flip side, short selling offers the advantage of time. Unlike with a put, there is no time limit on the trade, provided of course that we can keep funding any additional margin requirements that may be due to the broker.

While the holder of a put option´s losses are strictly limited to the contract premiums they pay at initiation, an option is highly likely to expire out of the money.

In contrast, the short seller could choose to wait it out if they believe the share price will fall in the long term. While being significantly more expensive than long puts, and with much higher potential losses, the short seller gets the advantage of time.

Short selling or long puts?

Both short selling or long puts can be used either to speculate or as a means to hedge risk.

Due to the risks involved, short selling should only be contemplated by sophisticated investors with deep pockets.

As the risk of loss from a long-put contract is limited to just the premiums paid at initiation, put options are likely to be much more suitable for the average investor.

To learn how short selling can work for your trading strategy watch our video:

Stock options trading: get call and put options ‘in the money’

As the name would suggest, options trading can provide investors with greater choice and flexibility.

Options are a type of derivative that can be used to make money from both rises and falls in asset prices. They can be used for speculation or as part of a strategy to control risk.

Options are contracts giving the holder the opportunity to buy or sell an asset at a pre-determined price (strike) and date (expiration). The word “opportunity” is important as the holder is not under an obligation to exercise their contract rights. They can simply choose to let the contract “expire” unexercised.

Once a strike price has been reached, few options buyers execute the option and buy/sell the underlying asset (perhaps just one in ten do this). Instead, the option is sold, often with the option writer offering a good price to buy the options back, closing the trade. If the option never reaches its strike price, it becomes worthless.

Once you cut through some of the jargon associated with options trading, you should be better placed to gain an understanding of how options can be effectively used. The key thing to remember with any derivative is that you don’t actually own the underlying asset.

Contract premium

Contract rights come at a price, with the holders of options contracts paying a non-refundable fee known as a “premium” at the initiation of their contract.

This premium, and the value of the option, are determined by the stock price, strike price, time remaining until expiration (time value) and the price volatility of the underlying asset in question – all things we’ll cover. It is hugely complex and changes over time.

The key is that the value of the option tends to increase the more likely an event becomes and decrease the less likely it is. Higher volatility increases the likelihood of a specific strike price being reached, for example. Conversely, an asset that has not fluctuated much might see its option value decline the closer to the deadline (expiration) as it becomes less likely a sudden price change will occur.

The option premium paid is crucial to calculating the profit generated from options trading as most trades are closed with the buyer selling their option at a different value.

On the bright side, our maximum loss is always limited to the premium. However, the premium’s non-refundable nature means we still lose it, even when there’s been very little movement in the underlying asset price.

Long call options

Buying a call option, known as a long call, enables the holder to use options trading to profit from rises in a given asset. Long-call contracts on a company’s stock provide the opportunity to theoretically buy its shares at a given price and within a fixed time frame.

For example, assume an option contract gives the holder the right to buy 100 shares of ABC company at a price of £180 until 30 December 2020, and suppose the stock is currently trading at £170 as of 30 October 2020. The option premium happens to be £5 per share, so £50 per option (100 shares).

In this case, £180 is the so-called “strike” price, while 30 December 2020 is the contract “expiration”. If the ABC shares move above the strike price at some point up to the 30 December then there is the potential for the holder to make a profit by closing the option – selling at its new price.

However, to calculate the profit, the option premium paid at initiation of the contract must also be factored in.

In the example of ABC, 10 long-call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).

Suppose the ABC share price has risen to £190 as of 5 December, and the call options have more than doubled in price to £10.50 per share.

If we were to close the position at this point, our profit from options trading would be: (1,000 x £10.50) – £5,000 = £5,500

In this example, options trading has enabled us to greatly magnify the profit impact from a rise in the shares of ABC. Although the share price only rose 5.5%, we more than doubled our initial £5,000 investment.

Long put options

Buying a put option, or taking out a long-put contract, is the opposite of buying a call option. A long-put holder can use options trading to profit from declines in the underlying share price.

For example, suppose an option contract gives the holder the right to sell 100 shares of ABC at a price of £160 until 30 December 2020, and assume the stock is trading at £170 as at 30 October 2020. The price of the option, or option premium, happens to be £5 per share, so £50 per option (100 shares).

As in the earlier example, 10 long call contracts covering 1,000 shares on 30 October would cost £5,000 (10 x £50 x 10).

Imagine the ABC share price has fallen to £150 as of 5 December, and the call options have more than doubled in price to £10.50 a share.

If we were to close the position at this point, our profit from options trading would be: (1,000 x £10.50) – £5,000 = £5,500

In the money (ITM)

In the two examples above, the options contracts are said to have been in the money (ITM) as the underlying share prices moved in the direction that the contract holder had hoped for.

However, when a contract is ITM, the holder will not always profit from exercising the contract. This is because the premium paid at initiation must be factored into the equation.

For example, imagine in the previous options trading example of the long put that the share price had fallen to £156. Suppose the options are now priced at £4.50 per share.

If we were to close the position at this point, the payoff would be: 1,000 x £4.50 = £4,500

However, although the put options contract is ITM (the share price is below the £160 strike price) if we were to exercise the contract at this point we would make a loss. This is because the premium paid at initiation was £5,000.

(1,000 x £4.50) – £5,000 = £500 loss

At the money ( ATM )

When an option’s strike price is equal to the underlying stock price, an options contract on a company’s shares is said to be at the money (ATM).

We would not choose to exercise the contract in this scenario as we would lose the entire contract premium that we paid at initiation. Up to the point of contract expiration, there is still a chance that the option contract will move into an ITM position.

Bearing this in mind, both volatility and time can be thought of as the friend of an option contract holder. When share price volatility is higher, and/or there is longer to go until contract expiration, the holder has a better chance of making money from options trading.

If the stock price remains unchanged or virtually unchanged by the time of contract expiration, the holder has still lost the contract premium.

Out of the money (OTM)

As the term would suggest, an out of the money (OTM) option describes the situation where an option contract has moved against the holder.

For a long call, this means the underlying stock price is below the strike price, while for a long put the share price would be above the strike price.

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If the option was still (OTM) at expiration, then the contract would expire unexercised. Again, it’s important to note that the options trading loss for the contract holder is always limited to the contract premium.

Intrinsic value

If an option is ITM, it is said to hold intrinsic value. In the options trading case of an ITM contract, the intrinsic value per share is simply the difference between the underlying stock price and the strike price of the options contract.

In the example of our long-call contract from above, the intrinsic value per share on 5 December is:

If an option contract happens to be OTM or ATM, the intrinsic value is always zero. It can never be negative, as losses for the contract holder will not exceed the contract premium. OTM or ATM options expire worthless for the holder.

Time value

In options trading, a time value generally applies to an option when it is trading above its intrinsic value.

Therefore: time value = current option price – intrinsic value

In the example of our long-call contract from above, the time value per share on 5 December is:

Putting it another way, the time value is a premium that investors are prepared to pay at a given point in time to acquire the option over its current exercise value.

Why would investors pay a premium, defined as time value? Because the longer an option has until its expiry, the more chance there is that the underlying share price will have moved to the contract holder’s advantage.

Thus, time value and the overall value of an option diminish the nearer a contract gets to expiration.

American options

The type of options that most of us will encounter in options trading, and the examples given earlier in this article, are defined as being “American” options.

An American option is simply one that can be exercised at any point up to and including the date of contract expiration.

The term does not relate to geographical location. For instance, most of the options traded in Europe are also American options.

European options

Conversely, the so-called “European” option has a lot less flexibility in options trading terms versus an American option. European options therefore tend to be less valuable.

Unlike American options, European options can only be exercised at contract expiration.

Given the constraints, European options are niche products that tend to be the domain of over the counter trades between institutions. Again, the term has nothing to do with geographical location.

Bermuda options

A Bermuda option combines some of the options trading traits of both American and European options.

Just like European options they can be exercised at expiration. However, they do exhibit some of the flexibility enjoyed by the holders of American options in that they can also be exercised on specific dates during the contract term.

This situation still falls well short of the opportunities afforded by American options, which can be exercised at any time during the term of the contract.

In options trading valuation terms, Bermuda options sit somewhere between American options at the top and European options at the bottom.

Writing options

The earlier options trading examples in this article dealt with the more common scenarios where investors choose to purchase contracts to benefit from potential upside or downside in share prices.

However, it is also possible to become the seller of a put or call option, or the “writer” of such contracts as the practice is termed.

As the writer, we always get to keep the premium the buyer pays at the initiation of the contract. However, writing options is certainly not for widows and orphans.

Becoming the writer of a call option means our losses from options trading are potentially unlimited.

In theory, there is no limit to an asset price’s upside. While this is good news for the buyer of a call option, it represents significant downside risk for the writer of the same contract.

As the writer of a put option, our potential losses are again, eye-wateringly large. There is, however, an upper limit to our losses in this situation, simply because an asset’s price cannot fall below zero.

Options strategies

There are numerous strategies that can be used in options trading.

One of the most popular of these is the protective put strategy. It can be thought of as a sort of insurance policy against falls in an asset that we own.

From the earlier example in this article, we know that acquiring a put option can enable us to profit from falls in share prices.

Suppose we hold a stock in our portfolio that we think could fall because of an upcoming company announcement. We believe the shares are a good investment in the long-term, so we do not choose to sell our holding outright.

Buying put options on the shares that we simultaneously own means we can offset losses from any short-term price weakness through the profits generated by our long-put position.

In this case, the cost of purchasing the put option is akin to an insurance premium.

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