Introduction to Put Option Strategies
This chapter is from the book
This chapter is from the book
This chapter is from the book
Surviving in Volatile and Falling Markets
Declining market value in stocks, alarming economic news, chronic housing and credit problems, uncertain oil prices—all these critical conditions that were worse than ever in 2008 and 2009 make the point that you need alternatives to survive in troubling economic times.
There is good news.
The options market is relatively young, but the popularity of options trading has grown exponentially every year since the early 1970s. This has occurred as increasing numbers of investors have realized that options are more than mere speculative tools. They are effective risk hedge instruments, cash generators, and portfolio management tools that virtually anyone can use beneficially. Even if you have very low risk tolerance, conservative options strategies can strengthen your portfolio and reduce market risks while generating current income.
In volatile markets, when you have no idea what stock values are going to be next month or even next week, options are especially valuable. In outright bear markets such as the market that started in 2007 and extended into 2009, put options offer a way to profit from declining stock values. This book is designed to explore a number of put strategies that can be used to provide profits when the markets are falling.
A put is an option designed to increase in value when the underlying security’s value falls. It is the opposite of a call, which is better known as an instrument that tracks a stock’s value and rises when the stock’s price rises. Traders often overlook put options because so many are naturally optimistic by nature. It is a common pitfall to believe that a stock’s value is always going to rise, and many investors treat their purchase price as a starting point from which values can only increase as time goes by. But anyone who was invested in the markets in 2008 and 2009 knows that this belief is flawed and also that it has expensive consequences. Stocks do fall in value. And when they do, it often defies logic. In 2008, rapid declines in stocks once thought to be invincible made the point that markets overreact. By the end of 2008, many stocks were available at bargain prices, but panic and fear were so widespread that few investors were brave enough to put capital into the equity markets.
This is the perfect market for option trading—and for a number of reasons. On a purely speculative approach to markets that have declined, low prices represent values; and when those prices bounce back (as they always do), anyone who got in at the lowest price levels makes handsome profits. However, if you are so concerned about declining stocks that you do not want to invest in shares, options provide attractive alternatives. The same is true when markets peak at the top. Overbought markets invariably correct; so if you don’t want to take profits, but you are concerned about declining values over the short term, options can be used to protect stock positions without having to sell shares.
There are so many possible uses for options and specifically for puts that you can take advantage of the potential in any kind of market. Whether prices are depressed or inflated, and whether the mood is bull or bear, puts are effective devices for maximizing profits. In volatile and falling markets, the value of puts is at a maximum. This is true because the mood in the markets is always fearful at such times. When market prices are rising rapidly, euphoria and even unjustified optimism rule, and in these conditions, putting money at risk is easy. But on the opposite side of the spectrum, when prices are low, doom and despair are the ruling emotions; and few people are willing to put money at risk in this environment.
All markets are cyclical, and that is why using puts as portfolio management devices should remain flexible. The most depressing market, whether in stocks, real estate, credit, or housing, is eventually going to come back and improve. When at the worst portion of a cycle, the situation always seems permanent, and investors cannot see their way to a recovery. But recovery does occur, and it always takes the markets by surprise. By the end of 2008, the P/E ratio of stocks on the S&P 500 had fallen from 26 three months earlier to about 18, a decline of more than 30 percent.1
This fall in the overall market’s P/E ratio defines the bear market of the time. This ratio, which tracks market sentiment about the future price direction of stocks, is far lower than it was only four years earlier when it peaked above 40; but many people are surprised to learn that the dismal 2008 numbers were higher than historical averages. A few decades ago in the 1970s, S&P 500 P/E fell into single digits and did not rise above 20 until the mid-1980s; so the decline in this important benchmark by the end of 2008 demonstrated that the current market is not as severe or as depressed as it has been in the recent past.
All these historical trends, when viewed in perspective, make the point that even the most volatile current market needs to be analyzed in context. Most market cycles last between two and five years, and the longer the downturn, the more rapid the recovery seems to be. Past cycles have demonstrated this interesting tendency time and again. What this means for investors is that volatility and uncertainty—as troubling as they are—present opportunities as well. And using puts to take advantage of volatility can be quite profitable in several ways:
- Producing short-term profits simply by timing buy and sell decisions based on rapid and volatile price changes;
- Protecting long stock positions by using puts as a form of insurance for paper profits;
- Entering into contingent purchase positions of stock using puts rather than committing funds; and
- Employing a variety of combined strategies to hedge risk while producing short-term profits and leveraged control over stock.
This book explains all the put-based strategies in detail and shows how even a troubled market presents great opportunities to keep you in control. The worst aspect of volatile markets is a sense of not having control over events, and puts can be used to offset this apprehension. You have probably heard that astute traders can earn profits in all types of markets. Puts are among the best devices to accomplish that goal.