Participate in Downward Stock Price Movement With Limited Upside Risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
ZYX is trading at $52.00. However, instead of selling 100 shares short an investor could purchase one six-month ZYX 50 put, which represents the right to sell 100 underlying ZYX shares at $50 per share, for a quoted price of $3.00. The total cost for the put would be: $3.00 x 100 contract multiplier = $300. By purchasing the put the investor is saying that by expiration he anticipates ZYX to have declined below the break-even point: $50 strike price (at which price ZYX can be sold no matter how low it has declined) - $3.00 (the option premium paid), or a ZYX share price of $47.00.
The investor's profit potential can be significant as ZYX stock price continues to decline below $47.00, and is theoretically limited because a stock can decline only to zero. The risk for the put purchase is limited entirely to the total premium paid for the contract, or $300, no matter how high ZYX stock price might increase.
Before expiration, if the put purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain. On the other hand, if the investor's bearish outlook proves incorrect and ZYX increases in price, the put might be sold to realize a loss less than the maximum.
Consider three possible scenarios at expiration:
- ZYX closes below the break-even point
- ZYX closes between the strike price and the break-even point
- ZYX closes above the strike price