Who Should Consider Buying Equity Puts?
- An investor who is very bearish on a particular stock and wants to profit from a decline in its price.
- An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.
- An investor who anticipates a decline in the value of a particular stock but does not want the unlimited upside risk or the commitment of capital needed for a short sale of underlying shares.
Buying an equity put is one of the simplest and most popular strategies used by bearish option investors. It allows an investor the opportunity to profit from a downward move in the price of the underlying stock while committing less capital compared to the potentially significant initial margin requirements needed for a short sale of an equivalent number of underlying shares, usually 100 shares per put contract. In addition, a long put holder is not subject to margin calls with an increasing underlying stock price as is an investor with an equivalent short stock position.
Buying an equity put gives the owner the right, but not the obligation, to sell 100 shares of underlying stock at a specified price (the strike price) at any time before a specific time (the expiration date). This is a bearish strategy because the value of the put tends to increase as the price of the underlying stock declines. This gain in option value will increasingly reflect a decline in the value of the underlying shares when the stock's market price moves below the option's strike price.
The profit potential is significant as the underlying stock continues to decline, and is limited only by a potential decrease in the stock's price to no less than zero. The financial risk is limited to the total premium paid for the option, no matter how high the underlying stock increases in price. Investors find this limited risk more attractive than the unlimited upside risk incurred from selling 100 shares of stock short. In addition, a short seller of underlying shares must pay any dividends distributed to shareholders while the short position is held; a put holder does not. The break-even point is an underlying stock price equal to the put's strike price minus the premium paid for the contract. As with any long option, an increase in volatility has a positive financial effect on the long put strategy while decreasing volatility has a negative effect. Time decay has a negative effect.