Options are financial contracts to buy or sell a particular stock at a set price for a specified period. A call option, which gives the owner the right to buy stock, is the most common type of option, but it's not the only type. You can also trade put options, which give the owner the right to sell stock. How you use a put option depends on what you want to accomplish.
If you expect the market price of a particular stock to decline in the near term, you might employ a long put option, which involves buying a put. Owning the put gives you the right, but not the obligation, to sell 100 shares of the underlying stock for a set price, called the strike price, until the option reaches its expiration date, at which time the option expires, becomes worthless and ceases to exist. If the stock's market price declines below the strike price, the value of your put option will rise. You don't have to own the underlying stock. You can instead sell your put option for its market price and pocket the profit. If the stock price does not decline below the strike price, the worst you can do is lose the premium you paid for the put option.
If you own a stock you think is vulnerable to a downturn in the market, but you believe the stock also has some good upside potential, you might consider employing a protective put strategy. This involves buying a put option on the same stock you own, but at a strike price that is below the stock's current market price. If the stock price rises, you get a nice gain on the stock, but your put option will expire and become worthless, so you'll lose the amount of the premium you paid for it. If the stock price plummets, you can exercise your put option and sell your stock for the strike price, limiting your loss on the stock to a predetermined level.
You can generate a steady stream of income by selling, also known as writing, cash-secured put options. This strategy involves selling put options with a strike price that is at or below the stock's current market price. You'll receive a premium for agreeing to buy the stock for the strike price if the put option is exercised. If the stock's market price increases, the option will expire, you get to keep the premium and you can sell another put option and collect another premium. If the stock price declines and the option is exercised, you have enough cash set aside in your brokerage account to cover the purchase price, which will be offset somewhat by the premium you received for selling the put.
Bear Put Spread
A bear put spread is a conservative option strategy that involves buying a put option while at the same time writing another put option on the same stock with the same expiration date but with a lower strike price. If the stock price declines below the long put strike price, the options value increases and you make a profit. You also have a profit from the premium you received from selling the put. The trade-off happens if the stock price continues to decline below the strike price for your short put, in which case the option could be exercised, requiring you to buy the stock.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.