Buying Put Options
Where you buy a put option with the expectation that the price of the stock will drop significantly beyond the strike price before the option expiration date.
Payoff Diagram: Buying a Put Option
In this example we are using the following assumptions:
Sol Price: $100
Will thinks that the the price of Sol is going down and wants to profit off of this, however he wants to reduce his potential downside, compared to a short call where the downside is potentially unlimited. Will could buy a put option to accomplish this.
With SOL trading at $100, Will thinks it will decrease over 10%. A put option contract with a strike price of $90 expiring in a month's time is being priced at $0.30. He decides to go long on 1000 put options with a strike price of $90, costing him $300 (1000 put options * $0.30). Now lets look at some scenarios:
Scenario 1 (The price of SOL rises):
If the price of SOL rises to $110, Wills 1000 put options at a strike price of $90 would expire worthless, meaning that Will would lose his initial outlay of $300. This is because the price has expired higher than the strike price of $90.
Scenario 2 (The price of SOL stays the same):
If the price of SOL stays the same, Wills 1000 put options at a strike price of $90 would expire worthless, meaning that Will would lose his initial outlay of $300. This is because the price has expired above the strike price of $90.
Scenario 3 (The price of SOL falls):
If the price of SOL falls to $89 before expiry, Wills put options are now worth $1.00 since you could exercise them and be short 1,000 SOL at $90 before immediately buying back at $89. Wills total position is now worth $1000 with a profit on the position of $700 (233%). Using a long put option allowed Will to realize a much greater gain than the 11% fall in the underlying price.
Why trade it? You think the price is going down within a certain time frame.
Optimal conditions? Cheap volatility, bearish asset.
Cost: The premium you pay.
Max Profit: If the asset goes to zero, you make the difference between the strike and zero, minus the premium you paid.
Max Loss: The premium you paid for the put.
Breakeven at expiration: The strike minus the price you paid for the put.