Option contracts come in one of two flavors – calls and puts. Fortunately, the structure of both vehicles is identical with the exception of one important distinction; call options grant you the right to buy stock while put options grant you the right to sell stock. We recently explored the dynamics of call options here. Today we turn our attention to options.
A put option is a contract that gives an investor the right, but not the obligation, to sell shares of stock (usually 100) at a specific price (the strike price) on or before the expiration date.
Just as buying call options serves as a cheaper, more leveraged alternative to buying stock, put options offer a cheaper, more leveraged alternative to shorting stock.
The beauty of buying a put over shorting stock is two-fold. First, the maximum risk when buying a put is limited to the cost of the put. When shorting the stock, the risk is theoretically unlimited. Second, when you attempt to short stock the shares have to first be borrowed from your broker before being sold in the marketplace. Occasionally you’ll come across stocks that are deemed “hard to borrow” meaning the shares aren’t available to short. With put options, this is never a problem. You always have the ability to place a bearish bet should the opportunity arise.
Suppose you believed interest rates are destined to rise in the coming year from their lowly levels (the ten-year yield sits at 2.5% while the thirty-year is at 3.3%) and wanted to position yourself to profit from such an outcome. Rising interest rates put downward pressure on bond prices, especially long-term bonds, so one logical strategy is to buy put options on a bond ETF such as the iShares 20+ Year Treasury Bond Fund (TLT).
Since the rise in rates will be gradual and undoubtedly take many months to transpire suppose you purchased a put option expiring in January 2016. With TLT currently trading around $114 let’s travel the more conservative route by purchasing an in-the-money (ITM) 115 strike put for around $11.50. Recall that in-the-money options have a higher probability of profit as they don’t require the underlying to move as far to break even.
As displayed in the accompanying risk graph, your max risk is limited to the initial $1150 investment while the max reward is unlimited until the stock reaches zero. To calculate the expiration breakeven, subtract the initial cost ($11.50) from the strike price ($115). If you held to expiration, TLT would need to fall to $103.50 to at least break even. That’s a drop of 10% over the next 18 months.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.