It’s been a shaky start to the year for stock prices.
But even when markets trend lower, we can find ways to protect our gains — and maybe even profit.
I hit on it in a recent episode of Ask Adam Anything on our YouTube channel.
So, let’s talk about the power of put options. (Keep scrolling for the highlights from my conversation with research analyst Matt Clark.)
Put Options Trading 101
Two Types of Option Trades
Matt: The market is all over the place. You may be wondering what your next move is.
There is a way to find profits when the market turns negative: put options. Adam is an expert on all things options, so I’ll kick things off with an easy question. Adam, what does an investing newbie need to know about a put option?
Adam: There are two types of options contracts that play two different sides of the market.
- Call options are options that you would purchase if you believe the price of an underlying stock or ETF is going to go higher. If you’re bullish on something, you will buy a call option.
- Put options are the mirror opposite of that. If you think prices will fall, you will buy a put option. And if prices do fall, then the value of that put option should go higher, and you should make money on that trade.
A lot of times, put options are a protection play. Let’s say you have a long stock portfolio. You are buying and holding for the future, but you’re worried about a correction, bear market or some type of negative price shock. You may buy put options to protect either part or all of your portfolio from that type of drop.
What Is a Strike Price When Trading Options?
Matt: A lot of investors are turned off by options trading because it seems complicated.
So, let’s walk through the components of a put option to simplify this valuable trading tool.
Let’s start with the strike price.
Adam: The “strike price” is the price at which you agree to buy or sell a stock if that option is exercised.
The important thing that you want to consider when you’re buying an option, whether it’s a call or a put, is: How much money do you want to invest in that option?
Your answer should be the amount of money you are willing to lose. Here’s why.
Let’s say you buy a call or put option, and the market goes against you — you could lose the full value of that option premium that you bought.
So I always recommend that you only invest an amount of money that you’re willing to lose and use that to help determine which strike you should buy.
Out of the Money … In the Money … What Does It Mean?
Matt: Can you talk about “out-of-the-money,” “at-the-money” and “in-the-money?” First, give a basic overview of what that means. And then second: Is there a higher reward with at-the-money as opposed to out-of-the-money?
Adam: Sure. So let’s use simple round numbers using a call option, an upside example, cause that’s sometimes easier for folks to visualize.
Let’s say shares of Company A are trading at $100 per share. That’s called the underlying stock that the options are on.
If you go to trade a call option on that underlying stock and you choose the $100 strike price, which is equal to the current price of the stock, that’s called “at-the-money.”
Anything above that price would be “out-of-the-money.” A call option with a strike of $110 would be an example here. It’s out-of-the-money because the stock price has to move from $100 to $110 before it’s at the money.
And then likewise, if you bought a $90 strike, that would be considered “in-the-money” because the stock price is already above that.
What Trades Have the Most Potential?
Adam: Out-of-the-money options give you more leverage. It’s a big “if,” but if you get the move and the direction that you expect, like if you want to trade a stock that’s at $100 and you think it’s going to go to $120 and that actually happens, then an out-of-the-money option will give you a greater return than anything else.
Now, that said, out-of-the-money options have a lower probability of success than at- or in-the-money options. That price move has to happen before you get much movement in the underlying option contract. So it’s kind of a balance between the probability of a winning trade with that contract and the amount of profit you take in on a winning trade.
Put It Into Practice: A Bearish Options Trade
Back in January, I recommended a bearish trade in my Home Run Profits premium options trading service. I saw an opportunity to make some money on declining prices in one particular market.
I recommended buying a put option that was out-of-the-money. There’s two main reasons you would buy an out-of-the-money option:
- They are cheaper. Out-of-the-money options are good for folks who only want to risk a small amount of money.
- You get more leverage on the underlying price move.
How did that trade work out?
My readers locked in a 100% gain — in just six days! — on one-third of these puts. So, even as markets trended lower, Home Run Profits subscribers capitalized.
If you’d like to learn more about how I use options for short-term profits in Home Run Profits, click here.
To good profits,
Adam O’Dell
Chief Investment Strategist