by Chris Rowe 08/19/08
RULE NO. 1: REALIZE YOUR RIGHTS AS A PUT BUYER
You must always remember that each option contract represents 100 shares of stock. If your option contract trades from $7 to $8 per share, then the value of the contract will go from $700 to $800. So, 10 option contracts represent 1,000 shares of stock, which means the value of those $7 contracts becomes $7,000 (i.e., $7 per share times 100 = $700 per contract times 10 contracts = $7,000), and so on.
Buying puts is similar to "shorting" a stock (which is betting on the stock trading lower by selling it first, and buying it back at a cheaper price). Instead of shorting the stock, you are purchasing an option "contract" that gives you the right to short (or sell) the stock.
Buying "in-the-money" puts carries less risk than shorting a stock. The most important thing to remember is that if you would only be willing to risk short-selling 500 shares of a $40 stock, then you should only buy five put options contracts on that same exact stock and nothing more.
In other words, buying 500 shares of a $40 stock is a $20,000 trade. (Although you are shorting the stock, you will eventually have to "cover" your position. Assuming the share price does not move, you would have to spend $20,000 to buy back the shares you shorted.)
If you would normally risk selling 500 shares short, then you certainly should NOT buy $20,000 worth of put options (which is a common and sometimes very tempting mistake to make). That would defeat the purpose of buying puts instead of shorting stock, and if you are wrong, you can lose your entire $20,000.
(This, by the way, is your maximum risk as a put option buyer, whereas your risk is unlimited when shorting stock, as the share price could climb infinitely, and you would have to buy back shares at the new market price to cover your short position.)
You must remember that you are taking a conservative approach using an options strategy in an effort to reduce your risk.
For example, if the put option is quoted at $7 (each contract representing 100 shares of stock, which means it will cost $700 per contract), then you should buy five put options (representing 500 shares), which would cost you $3,500.
If you invested that entire $20,000 in the puts, you are buying the right to short (or sell) almost 3,000 shares of a $40 stock. You must keep this perspective.
Which brings me to …
Bryan Perry
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