Buying Tin Put Options to Profit from a Fall in Tin Prices

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Put Options Under The Spotlight: When They’re A Safe Bet [And The Dangers Of Expiring Worthless]

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Last Updated on May 18, 2020

Buying put options is a bearish strategy using leverage and is a risk-defined alternative to shorting stock. An illustration of the thought process of buying a put is given next:

  1. A trader is very bearish on a particular stock trading at $50.
  2. The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply shorting stock.
  3. The trader expects the stock to move below $47.06 in the next 30 days.

Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44. For this example, the trader will buy only 1 put option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract). The graph below of this hypothetical situation is given below:

There are numerous reasons, both technical and fundamental, why a trader could feel bearish.

Options Offer Defined Risk

When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $44. Whether the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.

Options offer Leverage

The other benefit is leverage. When a stock price is below its breakeven point (in this example, $47.06) the option contract at expiration acts exactly like being short stock. To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100). Likewise, below $47.06, the options breakeven point, if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.

Remember, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500). However, the trader in this example, only paid $60 for the put option and does not need to worry about margin calls or the unlimited risk to the upside.

Options require Timing

The important part about selecting an option and option strike price, is the trader’s exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $75 or $47.51, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.

Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur–more complicated then shorting stock, when all a person is doing is predicting that the stock will move in their predicted direction downward.

Put Options Profit, Loss, Breakeven

The following is the profit/loss graph at expiration for the put option in the example given on the previous page.

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Break-even

The breakeven point is quite easy to calculate for a put option:

  • Breakeven Stock Price = Put Option Strike Price – Premium Paid

To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 – $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.

Profit

To calculate profits or losses on a put option use the following simple formula:

  • Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration

For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price – $45.00 stock price at expiration). So total, the trader would have made $206 ($2.06 x 100 shares/contract).

Partial Loss

If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money. For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price – $47.25 stock price). Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).

To summarize, in this partial loss example, the option trader bought a put option because they thought that the stock was going to fall. By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.

Complete Loss

If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44. Likewise, if the stock moved up, irrelavent by how much it moved upward, then the option trader would still lose the $0.44 paid for the option. In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).

Again, this is where the limited risk part of option buying comes in: the stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.

Buying put options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.

Downside of Buying Put Options

Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.

Put Options need Big Moves to be Profitable

Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:

  • 100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
  • 1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.

If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:

  • Shortseller: Gains $100 or 1.3%
  • Option Holder: Loses $44 or 0.6% of total capital

If the stock moves down 5% in the following 30 days:

  • Shortseller: Gains $250 or 3.3%
  • Option Holder: Loses $44 or 0.6%

If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:

  • Shortseller: Gains $400 or 5.3%
  • Option Holder: Gains $106 or 1.4%

It’s fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.

Capital Preservation

Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.

Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:

  • Shortseller: Loses $250 or 3.3%
  • Option Holder: Loses $44 or 0.6%

For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:

  • Shortseller: Loses $1,000 or 13.3%
  • Option Holder: Loses $44 or 0.6%

In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.

Moral of the story

Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:

  1. The direction the stock will move.
  2. How much the stock will move
  3. The time frame the stock will make its move

Put Options Trading – Buying Puts for Beginners

Put options are a bear’s best friend. Here’s why.

Bear markets and price corrections have plagued stock prices since the dawn of our modern marketplace. While it would be delightful to ban the volatility beast once and for all from Wall Street, such a fantasy only exists in the profit-filled dreams of perma-bulls.

Fortunately, educated investors have a number of weapons at their disposal to not only survive the occasional volatility attacks, but profit from them. Indeed, some skilled traders look forward to bear markets with downright giddiness as that’s when their bearish strategies really score.

Chief among these traders’ profit generating tactics is buying put options.

Perhaps you’ve heard of the puts bullish counterpart, the call option. While call options give you the right to buy stock, put options give you the right to sell stock. Here’s the full definition:

A put option gives the buyer of the contract the right, but not the obligation, to sell 100 shares of stock at a specific price on or before an expiration date.

This right to sell a stock at a set price becomes increasingly valuable as the stock price falls further and further. Let’s say Apple Inc. (NASDAQ:AAPL) is perched at $150 and I buy a three-month put option giving me the right to sell 100 shares of AAPL at $150. If AAPL stock were to fall to $130, then having the right to sell the stock back up at $100 would become quite attractive.

This is why buying put options is touted as a bearish trade and can produce big profits when stocks tank.

When you really begin to dig into the world of buying puts, you’ll discover they are quite the alluring alternative to shorting stock. Buying a put is a heck of a lot cheaper and offers a fair bit more leverage. Plus, you don’t have to borrow shares of stock to initiate your position.

The first step to buying put options is identifying a stock you believe will fall in value. Then, determine how long you plan on being in the position. Because options have an expiration date you have to choose how much time to buy.

Let’s say I think Wal-Mart Stores Inc (NYSE:WMT) is going to drop over the next two months. Rather than simply buying a two-month put option, try grabbing an extra month or two for good measure. It’s always better to have too much time rather than too little. Plus, you will limit the effect of time decay by using longer-term options.

The next choice involves selecting which strike price to buy. Buying in-the-money put options is more conservative so consider starting there. In-the-money puts are those with a strike price above the stock price. With WMT sitting at $75 we could buy a three-month $77.50 put for $3.20. Since put prices are listed on a per share basis, the $77.50 put would cost a grand total of $320, or $3.20 times 100. The initial cost also represents the max risk in the position.

The reward for buying put options is limited only by the stock falling to zero. Just like a stock trade, the objective of our put option play is to buy low and sell high. A big enough drop in WMT stock could send our $3.20 put option to $5, $6, $7 or even higher.

Once the stock has made the forecast drop, exit gracefully with profits in tow. Simple as that.

Short selling versus put options: a guide for investors

Short selling and buying put options can be used to profit from falling share prices. But what differentiates the two approaches and how do they stack up against each other?

Put options

With options, we pay a non-refundable sum of money, known as a contract premium, to gain the chance to profit from a move in an underlying security price.

Buying a call option allows us to profit from upward moves in shares, whereas buying a put option enables us to profit from down moves.

Buying a put option, otherwise known as taking a ‘long-put’ position, provides us with the opportunity to theoretically sell an underlying share at a predetermined price and by a certain date.

In practice, when an option contract position has gone our way, we should be able to simply close the position with one click on our laptop to realise profits.

When we purchase a put option, our maximum loss is always limited to the contract premium.

Profiting from puts

For example, suppose the shares of DriverlessCar Company are trading at $160, as at 1 May. A put option contract with a strike price of $150 expiring in a month from now is priced at $3.

We expect the stock price to fall over the coming weeks; we pay $3,000 to acquire put options covering 1000 shares.

Fortunately for us, at option expiry the share price has fallen to $140. Our put options are now ‘in the money’ with a total intrinsic value of $10,000 and we can now sell them for that amount.

In this simplistic example, the intrinsic value of our put options is equal to the difference between the strike price and the option price at expiry multiplied by the number of shares being covered by the contracts.

As we paid $3,000 to buy the put options, our profit from the position is $7,000:

Profit= $10,000 intrinsic value – $3,000 contract premium = $7,000

Limited risk

While put options can offer attractive returns, the downside is limited. Suppose the share price of DriverlessCar remains in a fairly narrow range before rising sharply at contract expiry to $185 after the company reports strong results from new product launches.

In this case, the put option was unprofitable, or in other words remaining ‘out of the money’.

On the bright side, even though the shares rose sharply before our option contracts expired, our loss is still limited to the $3,000 in premiums we paid at initiation on 1 May. The profit potential on a long put is also limited as a share cannot fall below zero.

While long puts can be used for speculative reasons, they are well suited for hedging the risk of a decline in the conventional portfolios and shares that we hold.

Consider the situation of a fund manager who is compelled by their mandate to always hold a certain percentage of a portfolio in equites during all market conditions, including bear markets.

Gains from long-put positions can be a welcome relief, offsetting at least some of the losses from conventional shareholdings.

At other times, rises in the value of our traditional holdings can easily counterbalance the contract premiums paid for our put options.

Low probability

It may all sound too good to be true, but the probability of an option contract being ‘in the money’ and providing us with a profit in its own right is typically only 25%.

The probability is a function of the volatility of the option and the length of the contract; the higher both these factors are, the more likely it is that the strike price on the long-put contract will be reached.

When it comes to options, volatility could be thought of as our friend – higher share price volatility increases our chances of making a profit. In a low volatility situation, when an underlying share price remains virtually unchanged, we´ve still lost the option premium that we paid at the initiation of the contract.

However, the cost of contracts on stocks with higher volatility will also be greater, reducing our potential for profit.

Buying contracts on stocks with lower volatility, but which we believe hold strong potential for share price movement due to events, can prove to be better value.

Some stocks are a lot more volatile than others, with ‘beta’ commonly used as a measure of share price volatility.

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For instance, a share with a beta of 0.9 could be thought of as being 10% less volatile than the market average. A share with a beta of 1.2 is theoretically 20% more volatile than the market.

Short selling

Like long puts, short selling enables us to profit from downward movements in share prices. As with puts, the potential gains are limited because a share price cannot fall below zero.

However, unlike using puts, the potential losses from short selling are theoretically unlimited.

To initiate a short-selling trade, we must borrow shares and then sell them in the market. If the share price drops as we hope, we can then buy them back at a lower price.

This price difference forms the basis of our profit from the trade. However, if the share price rises sharply, we are fully exposed to the resulting losses.

If the price does rise significantly, we could be compelled to provide additional margin (the money a broker requires as security for a trade) in addition to the initial margin we would have had to post at the outset of the trade.

Margin of error

One advantage of put options is that there is no such margin (borrowing) requirement involved. Typically, 50% of the total sale amount must be posted as margin at initiation of a short-selling trade.

This equates to $80,000 if we had sold short 1,000 shares in DriverlessCar Company when the share price was at $160 on 1 May.

If the share price had fallen to $140 as in the earlier example, our potential profit from short selling would have been:

($160 – $140) x 1,000 = $20,000

If the shares had subsequently risen to $185, our paper loss from short selling would have been:

($185 – $160) x 1,000 = $25,000

In this scenario, the put option contracts appear much more favourable as our losses were limited to $3,000.

Short selling entails less risk when the security being shorted is a market index or an exchange-traded fund (ETF). This is because individual shares carry much more potential for sharper movements.

Regulations have been imposed in recent years to make short selling more transparent. Some of the larger short-sale positions of financial institutions can be viewed on regulators´ websites.

*excludes cost of borrowing stock short or any interest payable on margin account.

Time advantage

On the flip side, short selling offers the advantage of time. Unlike with a put, there is no time limit on the trade, provided of course that we can keep funding any additional margin requirements that may be due to the broker.

While the holder of a put option´s losses are strictly limited to the contract premiums they pay at initiation, an option is highly likely to expire out of the money.

In contrast, the short seller could choose to wait it out if they believe the share price will fall in the long term. While being significantly more expensive than long puts, and with much higher potential losses, the short seller gets the advantage of time.

Short selling or long puts?

Both short selling or long puts can be used either to speculate or as a means to hedge risk.

Due to the risks involved, short selling should only be contemplated by sophisticated investors with deep pockets.

As the risk of loss from a long-put contract is limited to just the premiums paid at initiation, put options are likely to be much more suitable for the average investor.

To learn how short selling can work for your trading strategy watch our video:

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