Put Option Trading Strategies

A put gives the buyer the right to sell the underlying at the strike price until expiration; they are not obligated to do so.  The seller of a put has the obligation to buy the underlying from the option buyer, if they exercise their right.

These graphs show the risk-reward to a put option based on whether you buy it or sell it, and also note that you can combine a put buy and put sell into one trade and get a different risk-reward.  When you have done this your position is called a spread; you can have a long spread or short spread.

I am going to show you a series of profit graphs for puts, and the various trades that can be done.  These graphs show what is called math to expiration, meaning what your option profit or loss would be if it was held until expiration day.

When you buy a put you have limited risk and unlimited gain.  This profit graph shows buying 1 put at a 30 strike price for $2.00.  You can see that your risk is limited to $200, or what you paid for the put, and that your gain goes up $100 for each 1 point decrease in the underlying price below 28.00, which is your breakeven point.  This is calculated simply by subtracting the cost of the option from the strike price = 30 – 2.00.

When you sell a put you have limited gain and unlimited risk.  This profit graph shows selling 1 put at a 30 strike price for $2.00.  You can see that your gain is limited to $200, or what you sold the option for, and that your risk goes up for each 1 point decrease in the underlying price below 28.00, which is your breakeven point.  This is calculated simply by subtract what you sold the option for from the strike price = 30 -2.00.

Put selling is used as a strategy to gain the premium if the stock remains above the short strike, but also as a way to buy a stock at a cheaper price.  Remember, that when you sell a put you have the obligation to buy the underlying from the put buyer.  Consider xyz is at 32.00 and you don’t want to pay that much for the stock, but you would be willing to buy it for 28.00.  So, you sell the 30 put at 2.00, and if it goes below 30 at expiration you will be assigned the stock, and have a 28.00 cost basis in it = 30 strike – 2.00 put sell.

As shown above, you could buy a put to participate in a selloff in a stock, but you could also buy a put (1) protect your gains in a stock that you own (2) limit your losses in a stock that you are going to buy.

On this profit graph you can see the far right column, which would show the risk-reward from buying 100 shares of xyz at 27.00, where you would gain or lose $100 for every point increase or decrease in the underlying above or below 27.00.

Now consider that you bought the stock and in went up for you, and you then bought a 30 put for 2.00 to protect your gains in the stock.  Yes, you will limit further increases in the stock by the cost of the put, where instead of continuing to gain 1:1, you will not gain any more until 32.00 = 30 strike + 2.00 put cost.  However, you have also eliminated any losses in the stock, and actually have turned your risk into a minimum gain of $100 = 30 strike – 27 stock cost + 2.00 put cost.

On this profit graph you can again see the outside column and the risk-reward of buying xyz at 27.00.  Instead of just buying the stock, you decide to buy the stock and buy a 25 put for 1.00.  You will reduce your gains by the cost of the put, so instead of gaining 1:1 above 27.00, you will gain 1:1 above 28.00 after absorbing the cost of the put.  However, you have also turned your position into one that has a maximum loss of $300, instead of 1:1 below 27.00 – your maximum loss = 27.00 stock cost – 25 strike – 1.00 put cost.

When you buy a long put spread, you buy 1 higher strike put and sell 1 lower strike put.  By doing this you have limited risk like the long put, but you have further reduced the size of that risk.  However, you have also gone from having unlimited gain to limited gain.

Why would someone do this strategy?  Let’s say xyz has been in a range from 25.50 to 30.50 for the last few weeks, and has just move up to 30.30.  So, you now want to buy a put spread to get a bounce back to the 25.50 area, instead of having unlimited gain below a point that you don’t think the stock will reach. 

When you look at this profit graph, you can see that your maximum risk is $100 or what you paid for the spread, and your maximum gain is $400, which will be achieved if the underlying goes to 25.00 or lower at expiration.  If the underlying goes to 25.50, and your target price, then you will make $350 = 30 strike - 25.50 - $100 position cost.

When you sell a short put spread, you sell 1 higher strike put and buy 1 lower strike.  By doing this you have limited gain like the short put, but now you have limited risk instead of unlimited risk.

Why would someone do this strategy? There are a number of strategies developed for selling options for income, and selling put spreads would be one of them. 

The plan would be similar to that of the long put spread, where you identify the range for a stock, and then sell a put spread that is below the range.  For instance, xyz has been in a range from 32.00 to 36.50 for the last few weeks, and has just move down to 32.40.  So, you now want to sell a put spread below the range, where you don’t care whether the stock goes back up, you just don’t want it to go lower.

I can’t say that I really like the idea of risking $400 to make $100, but this kind of risk-reward ratio is typical, and part of the strategy.  If the stock is at the bottom of its range, with an anticipated move to go back up to the top of the range, selling a put spread would be a strategy to profit in this.

When you look at this profit graph, you can see that your maximum gain is $100, which you will get providing the stock remains at or above the short strike.  You can see that you will lose money above 29, which is your breakeven = 30 short strike - $100 spread sell price – this is also called a credit, which makes short spreads known as credit spreads.  Your maximum loss comes at 25, or the long strike in the spread.