Buying Puts- Understanding Options for a Bull & Bear Market Part 2

Buying Puts- Understanding Options for a Bull & Bear Market Part 2

 

Buying Puts- Understanding Options for a Bull & Bear Market (Part 2)

 

Call buying for the bull side, obviously, this makes sense that we’re going to flip over to the put side to be bearish and I have a few things to say about here.

First, the example buying the $35-strike put, this is in comparison to shorting stock. Many of you may not ever short shares of stock and may not want to, some of you might, but for many of the investing public they’re not shorting stock in an effort to capitalize on a move lower. Put buying is one choice they have. Similar to calls you’re paying premium up front, and in this case, we’re buying the $35 strike and we’re paying $2.25 for it. We would need the move to not only be lower, but be low enough by a magnitude of a share price and in the horizon that we expect in order to be profitable again. Difficult, but can be done and you can see nice returns on a trade like this.

If you’ve got all of those pieces lined up. I’ll give you an example here of one that didn’t work out, don’t mean to scare anybody, but it’s easier to remember the ones that didn’t work out to try and avoid problems or surprises and this goes back – I’ve used this example before. This goes back to last year, a stock was trading around a hundred and an investor had bought the $80-strike put option. So, 20 percent out of the money few weeks go by and earnings announcement gets released and the stock gets hammered by about 15%. Is now trading $85 the option still had a few weeks to go and this investor was virtually at breakeven. They were very slightly positive on the trade and a stock was crushed 15%. So again, investor was confused. What happened here? And why did I not see a greater gain.

While taking a quick look at it, I could first of all see that it wasn’t wide bid-ask spreads that were getting marked not in his favor. There was trading, there was a decent amount of volume. So, the market wasn’t taking anything from him. The market was trading where it was supposed to be trading, buyers and sellers at the right price. So, what happened? You know, I felt comfortable enough saying well, first of all, as I said with the call buying you had earnings announcement. Any time you have that you get an overall volatility crush and that’s going to have a negative effect on your option price. But, in this case you also had something else going on. There is volatility skew, where the lower-priced strike prices have a higher implied volatility and that implied volatility starts to come down. And if you are plotting this on a graph it would start on the left at the highest level and it starts to come down all the way to the at-the-money level and just above that you would see where the implied volatilities bottoms out.

You have this curve that slopes down, forgetting about the upside just looking at the at the money and to the downside puts you have a fairly steep slope and with highly volatile stocks that have a tremendous amount of risk that slope can be very steep. Now, thinking that through he bought the option it was 20% out of the money. Compared to the at the money level, it was very low. So at a very high implied volatility level on the curve itself after a 15% move lower his option now is about maybe five, six percent out of the money and it slid up the curve all the way from twenty percent out of the money to now say five percent out of the money. It’s sat on a very different place on the curve much closer to at the money. So, if you followed that not only did you have an earnings announcement which dropped the entire curve lower, but you also had this slide along the curve that was very steep. So, the option now set at a different place, both of those effects really had a negative impact on the long put position that this investor had.

Understanding those things is important and how volatility changes can impact the prices of options is important. There certainly is money to be made buying options and we will walk through some other examples as well, but having an understanding of volatility and the direction timing and magnitude all locked in if you want to be comfortable with where you’re at is when you would want to take these positions. On the flip side here covering the last outright position selling a put option, usually it’s done cash secure. Doesn’t have to be done that way. But usually it is, it could be considered a bullish strategy if you are bullish, but very cautious and very conservative and you’re not concerned about the stock moving much higher.

Maybe selling put could fit the category of bullish, but I don’t have it here as an example because that would be extremely cautious and very mildly bullish. Cash secured puts you might use on a more neutral environment or if you are looking to purchase shares and weren’t comfortable with the current stock level selling puts out of the money is very popular there. So, focused on the two buying sides and buying calls and buying puts. Touch down the sell side a little bit.