How I Use Put Options

Recently, to take advantage of the market volatility, I've been using options to augment my investment earnings and reduce my investment losses. For me, using call and put options work best when the market is choppy with many ups and downs, which is the current state of the stock market.

As brief background, the owner of a put option has the right to sell a stock at a specific price, while the seller of a put option has the obligation to buy a stock at a specfic price. The owner of a call option has the right to buy a stock at a specific price, while the seller of a call options has the obligation to sell a stock at a specific price. For a detailed explanation, see the Wikipedia definition for a put option and a call option.

For this post, I will focus on my use of the put option. I will write about how I use a call options in a future post.

A common use for a put option is for the owner of a stock to buy a put as insurance against a fall in the stock price. For example, if I own 100 shares of Energy Conversion Devices (ENER), which closed today at $22.05, I can buy a December, 2008 put with a "strike price" of $17.50 for $0.60. Thus, for $0.60per share of Energy Conversion Devices, I have the right to sell the stock for $17.50 anytime before December 19, 2008. Of course, I would not want to use this right unless Energy Conversion Devices was below $17.50. I typically do not use put options in this manner.

I prefer to be the seller of put options. For example, if I wanted to own 100 shares of Energy Conversion Devices, but only wanted to pay $17.50, I could put in a limit buy order at $15. If Energy Conversion Devices falls from $22.05 to $17.50 or below, a purchase of 100 shares will be made. However, if Energy Conversion Devices stays above $17.50, no purchase is made.

Another approach, which I am currently using, is to sell one December, 2008 $17.50 put option contract for $0.60, which obligates me to purchase 100 shares of the stock at $17.50. If the stock falls below $17.50, I will likely end up purchasing the stock, at $4.55 less that today's closing price. If the stock stays above $17.50 until December 19, 2008, then I don't purchase the stock but I make $60 ($0.60 X 100 shares). In this case, I get paid for waiting, even though I don't buy the stock.

One risk with limit orders or selling put options is that a stock not purchased rises significantly, and one loses all the gains that would have occur ed if the stock has been purchased at market. For me, this risk is a concern during a bull market, but much less so during the choppy markets we are currently experience. Another risk is that the stock continues to fall, far below the strike price. Of course, this is a risk with the purchase of any stock.

An example of my current use of put options can be found in the 12/7/08 Bottom Fishing Portfolio Update.

While selling options short is inherently high risk, I minimize my risk by having sufficient cash available, in case I am required to buy the 100 shares of the stock.

Disclosure: At the time of publication, I am short one December, 2008 $17.50 put option contract for Energy Conversion Devices, which I sold for $1.39 per share on November 25, 2008.

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This is not financial or investment advice. Please consult a professional advisor.

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