Prices Plunging? Buy a Put!

As you become more informed about the options market, you will need to learn how to use a long or short position in either a rising or falling market. Going long on a call is a profitable strategy when the underlying stock price rises in value. If you suspect a stock is going to fall in value, that is when you will be turning to puts. Puts are essentially the opposite of calls and have different payoff diagrams. Read on to find out how they work and how you can use them to profit even while a stock is plummeting. 

[Note: Some people buy puts as insurance on stocks they own to insulate themselves from a drop in share prices. But puts can also be used to speculate and generate profits on falling stocks. See veteran options trader Luke Downey break down options with easy, relatable examples in Investopedia Academy's Options for Beginners course.]

Going long on puts should not be confused with the technique of married puts. Married puts describe a strategy for protecting your portfolio from a steep decline in shares that you own by using a put as a form of insurance to limit losses. 

Instead we are focusing on buying puts as a means to speculate on falling share prices. The major difference is that there is no ownership in the underlying shares - the only ownership is of the puts. Opening such a long position in your brokerage account involves "buying to open" a put position. Brokers use this terminology because when you buy puts, you can be buying them either to open a position or to close a position. Opening a position is self-explanatory, and closing a position simply means that you are buying back puts that you had sold earlier.

Besides buying puts, another common strategy used to profit from falling share prices is selling the stock short. You do this by borrowing the shares from your broker and then selling them. If the price falls, you buy them back at a cheaper price and return them to the owner while keeping the profit.

Buying puts instead of shorting is advantageous for the same reasons that buying calls is more advantageous than buying stocks. In addition to leverage, you also get the ability to buy puts on stocks for which you cannot find the shares to short. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because your broker does not have enough shares to lend to people who would like to short them.

In such a case, puts become very useful because you can profit from the downside of a "non-shortable" stock. In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put.

Let's consider stock ABC, which trades for $100 per share. Its one-month puts, which are at a strike price of $95, trade for $3. An investor who thinks that ABC shares are overvalued and will fall below $92 within the next month will buy the puts at $3. In such a case, the investor must pay $300 ($3 x 100, which is how many shares one option contract controls) for the put, which is illustrated in the payoff diagram shown in Figure 1 below.

Figure 1: Payoff Diagram for a Put

There are some important things to note from the diagram. The first is that the breakeven point for an investor in the puts is $92/share ($95 strike price minus the $3 premium). Also note that while the maximum loss of $300 occurs at prices of $95 or higher on ABC, the profits grow larger at prices below $92. 

Closing out a long put position involves either selling the put or exercising it in the open market. Let us assume that you are long the ABC puts from the previous example, and the current price on the stock is $90, so the puts now trade at $5. In this case, you can sell the puts for a profit of $200 ($500-$300). If you wished to exercise the put, you would go to the market and buy shares at $90. You would then "put" (or sell) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit in this case is also $200.

The distinction between a put and a call payoff diagram is important to remember. When dealing with long calls, the profits you might obtain are limitless, because a stock can go up in value forever (in theory). However, a payoff diagram for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95, because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0.

Puts are a great way to profit from a fall in a stock's price. Such a position has inherent advantages over shorting a stock, but investors must be careful not to over-leverage their positions. If used properly, puts are an excellent way to profit from downside because your losses are limited to your option premium.