Market Opinion?

Bearish to Very Bearish

The purchase of a long put allows the investor to profit from a downward move in the underlying stock.  Much like the call, the put will provide the foundation for many more advanced strategies.

Application

Buying a put without owning the underlying shares is considered a directional strategy used for bearish speculation.  The put holder is seeking to profit from a decrease in price of the underlying security.  As with the call, the investor wishes to limit his or her initial investment, taking advantage of the leveraged position the purchase of put contracts will offer.

Since puts behave much like calls, proper selection of the underlying stock, option strike price and option expiration is crucial.  The more out-of-the-money the put contract is, the larger the downward move in the  share price of the underlying required to break-even.

Benefit

A long put offers an alternative to a "short sale" of the underlying stock with  Offering less potential risk to the investor. An investor who is holding a long put has a predetermined, limited financial risk versus the unlimited upside risk from a short stock sale. Purchasing a put generally requires lower  capital commitment than the margin required to establish a short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits.  As the contract becomes more profitable, the risk versus reward benefits are realized.

Risk vs. Reward

Maximum Profit: Limited to the shares in the underlying falling to zero.

Maximum Loss: Limited to Net Premium Paid

Despite the fact that losses are limited to the premium paid, the potential reward must be considered against the potential loss of the entire premium.

Volatility

The Implied volatility of an option is a measure of the amount by which the underlying security is expected to fluctuate over a period of time.  It reflects the markets expectations and can change at any time based on news or other events affecting the stock.

Volatility Increases:  Positive Effect
Volatility Decreases: Negative Effect

Any effect of volatility on the option's total premium is on the time value portion.

Time Decay?

Passage of Time: Negative Effect

An options time value portion will decrease as an option moves closer to expiration. The rate of time decay increases considerably with in the last month before expiration.  It is important to give yourself sufficient time for a move in the underlying to take place.  

To determine the time value portion of an options premium:

Premium - Intrinsic value = Time Value

Before expiration?

An option holder can sell the put in the options market to close out the position.  This may be done in order to realize a profit or to cut losses on a losing trade.  

The presence of  Market Makers on each of the six option exchanges insures liquidity in the absence of public orders.

Upon Expiration?

Because equity options are standardized derivatives, they expire on the third Friday of the expiration month.  If the option has any intrinsic value or, in other words, the option is in-the-money, the holder may elect to sell the contracts for a profit before the end of the trading day.  As an alternative, the holder may wish to exercise thereby selling the equivalent shares at the strike price and establishing a short stock position.  

If the option is out-of-the-money, it will expire worthless.

 An Example

As mentioned, before puts came into existence, the only alternative for a bearish investor was to short the stock. This is considered to be an incredibly risky strategy. In the event of a bullish run, the loss could be theoretically unlimited.  Instead of exposing his or her portfolio to such risk, the investor could buy puts (the right to sell the stock at a fixed price).

If Symantec Corporation  (SYMC) is trading at $19.95, suppose the April $17.50 puts are trading for $0.55 per contract.  One April $17.50 put could be purchased for $55.00 (100 shares x $0.55).  Because each contract controls 100 shares, the bearish investor now has the right to sell 100 shares at $17.50 per share. If the stock stays at or above $17.50 before the option expires, the most he or she could lose is the initial investment of $55.

Conversely, if the stock falls to $10.00, the April 17.50 put will be worth at least $7.50 (strike price: $17.50 – current stock price: $10.00) upon expiration.  If this move should happen any time prior to expiration, the put contract would be worth the intrinsic value plus any time value remaining. With the stock at $10.00, the put is worth $750.00 ($7.50 x 100 shares). After subtracting the cost of the premium paid and before commissions your gain is $695.00, a 1263% gain on your investment.

If the bearish investor sold the stock short at $19.95, expecting it would go down, and it rose quickly to $25.00, the stock may be bought back to close the position, and thus limiting losses. In this example, the loss would be $505.00 (100 shares x $5.05 share). If the stock continued to climb the losses are conceivably limitless.  If the investor had  purchased puts rather than selling the stock short, the losses would be limited to the price of the puts, in this case $55.

As with the long call option, the holder of the put option must be correct with respect to the movement of the underlying stock, as well as the time frame in which it will occur. If the stock fails to make a move prior to the options expiration, they will expire worthless. While a stockholder is concerned with market direction, the timeframe isn't as critical because stock doesn't have an expiration date. Conversely, most options expire in a matter of months.