15-year market maker uncovers these ‘little-known’ trading strategies. You should really learn what a Put Options is
A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date.
The seller of a put option takes on the duty of accepting delivery of the stock or other underlying instrument from the buyer should the buyer want to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down.
For the seller to gain, the stock must not move below the strike price in addition to the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the call’s strike price to the option’s premium. Of course, the purchaser wants the stock price to go beyond the breakeven point.
i.e. you purchase the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the permission, but not the requirement to sell the stock at $65.00. In order to obtain this right, you had to spend $2.00. In order for you to make a profit, the stock would have to fall below $63.00 by expiration.
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This is because the stock has to trade down below the strike plus the cost of the option. If the stock traded down to $60.00, you would gain $5.00 because you have the ability to sell it at $65.00. On the other hand, because you paid $2.00 for the put, you must deduct that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a two Dollar.00 investment. An excellent return.
The purchaser of the put has reduced risk and limitless possible gain. His risk is restricted simply to the sum of cash he spent in buying the put. His unconstrained possible profit derives from the stocks limitless downside potential.
The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the put. The unlimited risk comes from the stock price’s ability to decline during the life of the contract.
i.e. if a seller released the MSFT January 65 put for $2.00, he is offering the buyer the right to sell 100 shares (per contract) of MSFT to him at $65.00 per share at any time up to the point when the option expires.
If MSFT drops and trades lower at $55.00, the seller crystalizes a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. For the time being, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net profit of $8.00 per contract.
If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to receive the stock from the buyer at the strike price irrespective of the current market price of the stock. This is why the seller receives premium for the sale.
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