What are the Best Tips for Put Option Trading?

Jim B.

Put option trading is a type of investment opportunity in which an individual buys the right to sell 100 shares of an underlying stock at some point in the future. The buyer of a put option hopes that the price of the underlying stock will fall, while the seller hopes that it will rise. Buying put options is the safest form of put option trading because the buyer risks only the premium, which is the cost of buying the option. Selling put options is riskier, so the seller should try to manipulate the strike price, which is the price below the current underlying price at which the buyer may exercise the option.

Man climbing a rope
Man climbing a rope

Options trading is a bit more involved than typical stock trades, but it can be profitable to investors if they can predict the movement of stock prices and the timing of that movement. The two main types of options are calls, which allow the buyers the right to buy 100 shares of an underlying stock, and puts, which allow buyers to sell 100 underlying shares. These options may only be exercised when the strike price is reached and before the expiration date of the option. Put option trading requires buyers to be bearish on a stock, which means that they expect the price to drop and sellers to be bullish, meaning that they expect the price to rise.

In put option trading, buyers only have to risk the original amount for the option, which is known as the premium, while they have unlimited potential for profit if the underlying stock price falls way below the strike price. For that reason, buying put options is a safer bet for newcomers to the practice. Buyers should be looking for stocks whose actual value, as determined by earnings reports and other common investment metrics, is well below what its current stock price might suggest.

Sellers of put options can only gain the premium, but they can conceivably lose large amounts. One way to mitigate this risk is to determine the volatility of the underlying stock and adjust the strike price accordingly. In put option trading, the strike price is set below the current price and, if reached, allows the buyer the chance to exercise the option. If it is never reached, the option is worthless and the seller pockets the premium.

When a seller feels like the underlying stock is relatively stable, he should set the strike price close to the current price. This would allow him to demand a higher premium from the buyer. A seller who considers the underlying stock a bit volatile should keep the strike price low. That would protect him somewhat from a price drop, although it would also mean less of a premium payment from the buyer.

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