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All options strategies are built on a knowledge of the straight purchase of puts and calls. A discussion of a straight call purchase can be found here. It includes a description of “time value,” “intrinsic value” and several other important options fundamentals.
In this article, however, we round out our discussion of the basics with a look at a straight put purchase.
Most beginner traders believe that a long put purchase is a simple matter of buying before the stock moves lower, leading to instant riches.
And while that may be the case in a select minority of trades, seasoned traders are more aware of the odds and therefore conduct a few basic calculations before taking on a straight put (or call) purchase.
Before we crunch the numbers, however, it’s also important to know that any straight options purchase has the potential to result in the loss of one’s entire investment. You can’t lose any more than you initially put up, but that’s cold consolation come expiration, when your put or call is sitting out of the money and your cash has evaporated.
With that in mind, it’s important to consider the following:
- Your “break-even” level for the trade – that is, the price at which the underlying security must trade before you at least get your money back.
- Early closure of the trade – the level at which you determine prior to entering the trade that you will sell your option at a loss.
Let’s look at a real-life example to get some clarity.
Below is a chart of the SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA), a security that tracks the movements of the index. As you can see, the chart encompasses a period marked by a steep decline and a subsequent sharp rise.
Seeing that the former lows have been taken out, and expecting further declines, you decide toward the end of August to purchase a put option (red circle). DIA is sitting at exactly 172 intraday when you buy the at-the-money November 172 put for $4.00.
That means your put option will be in the money as soon as DIA falls below $172. But you won’t break even on the trade until it falls to $168 ($172 [the option’s strike price] – $4 [your price for the option]). The green line on the chart represents the break-even line. That’s also the price at which you decide to close the trade should the stock turn about and begin to rise.
Now let’s examine two possible trading scenarios:
- The first is a possible sale on the first of September (first blue circle). With the stock at $161 you see your option trading for $13.50. That’s $11 worth of intrinsic value and $2.50 worth of time value. It’s also a 175% profit in just a week and a half! And that’s pretty darn good.
- The second is a sale you’d likely rather not make. Having bounced off the late August lows, DIA ascends above your break-even line in October (second blue circle), forcing you to honor your commitment to yourself to close out the trade at a loss. On that date the option no longer possesses any “intrinsic value,” as it’s trading out of the money. But it still has $1.50 worth of time value, so you take it. Your loss is $250 ([$4 – $1.50] x 100) – better than the full $400 loss you’d face by holding to expiry, but patently not as good as the earlier alternative.
So remember: It’s very often the case that early closure of your straight options purchase will yield better results than holding to expiry.
Good luck!
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