Dear Penny Stock Millionaire,
Yesterday, I gave you the rundown on what put options are, and how they work. Today, I’m going to focus on how to buy, and profit from put options.
Buying a put option means you start from behind and try to predict a future price decrease.
Buyers pay the premium to the seller and a commission to their brokerage. The buyer needs the price of the underlying stock to go below the strike price to be in the money. And they need the price to drop below the strike price enough to exceed the cost of the premium and commissions they paid to turn a profit.
Let’s go back to the TSLA example from yesterday.
Let’s say I pay a $4.70 premium for the put with a strike price of $355. I need the price to decline to about $350 to break even.
If the price fell further to $340, I’d make $10 per share. This is where options can really pay off. If the price was to fall to $300, I’d make $50 per share. On a 100 share option contract, I could make $5,000 while only risking $500. Pretty nice return I’d say.
Writing Put Options
If there’s a buyer, there must be a seller. Options sellers are also known as writers. They essentially write the contract and put it up for sale.
The seller seemingly takes a position of lower risk. But much like shorting a stock, when you write a put option there’s no maximum risk when you sell it. Once you sell put options, you keep the premium no matter what. Until the contract expires, the seller must buy at the strike price even if the current price is now far below the strike price.
Keeping with the TSLA put above, the writer sold a put option for a premium of $4.70. It’s up to the buyer to decide the best time for exercising a put option. If the price drops to $300 and the buyer decides to exercise his option, the writer must buy at the strike price.
The contract writer must pay $355 for a stock that’s only worth $300 on the open market.
Selling options, much like shorting a stock carries a huge potential risk.
Selling Put Options
As the expiration date nears, the option price declines since the chance of a big drop goes down as the date draws closer.
Sellers are the writers — they write and sell the contract to the buyers. Sellers have more than one way to profit, but their profit is limited to the premium the buyer is willing to pay.
A seller sells a short put position. At any point, a seller may cover a position by buying another put option with the same strike and expiration. This works the same as covering a stock that you shorted.
FOR EXAMPLE, say I sold the premium we talked about before for $4.70. As the expiration date nears and the stock price holds steady above $355, the premium would decline. That’s known as time decay. If the premiums fall to $2, I could buy at the price to lock in a profit and keep the difference of $2.70.
If I didn’t buy to cover my position and let the contract expire with the stock price at or above $355, I’d keep the entire premium. I’d make a profit of $4.70 per share of the contract.
The seller of an option contract can make money when the price moves sideways. Every other trader in the market needs the price to move to make a profit. When the price stays the same, sellers keep the premium and receive the put option payoff.
Put Option Examples
Here are a few basic examples of put options and what needs to happen to turn a profit.
Check out the chart of Beyond Meat, Inc. (NASDAQ: BYND) puts below.
Put Option: BYND © 2019 Millionaire Media LLC
On December 13, BYND closed the day around $75. If I’m convinced that the price will drop further in the next month, I could buy a put options contract for $445 total.
When the price reaches $70.55, I’d break even. If the price drops lower, I’d make the difference times 100. So if the price continues to $60, I’d make $10.55 per share or $1,055.
But if the prices stay above $70.55 until January 17, I’d lose money.
Look at the chart of Netflix, Inc. (NASDAQ: NFLX) puts below.
Put Option: NFLX © 2019 Millionaire Media LLC
At the close on December 13, NFLX was at $298.50. I can buy a put option with a strike of $300 for $1,120 if I’m bearish and think it’ll go down further.
I’ll lose money if the price stays above $288.80. I only stand to profit when the price falls below $288.80. I’ll lose my entire premium to the seller if the price is above $300 on January 17.
Put Option Formula
There are so many ways to trade options. The formulas can get very complex as you buy and sell multiple different contracts to hedge your bets.
Here are a few basic options formulas to help give you an idea of everything you need to consider when trading options.
You can put these into a spreadsheet to create your own put option calculator.
These formulas work on the buying side of put options…
= [Strike price] – [current stock price] – [premium]
You’re in a profitable trade if your number is positive. But if the number is negative, you’re sitting on a loss.
= [strike price] – [premium]
This formula lets you know as a buyer what the price needs to decline for you to break even.
Price of Contract
= 100x [premium]
Remember that the price you see isn’t the price you pay.
Where to Trade Options
You can trade options through a reputable brokerage. Some do it better than others. Other factors you should consider are your account size and trading style.
If you trade with a $3,000 account, you need a different brokerage than someone with a $30,000 account. Just as those who trade all day on a desktop have different needs than someone managing a swing trade on a smartphone
Deciding on the right brokerage is unique to your individual needs. Don’t open an account just anywhere. Find the right brokerage for your needs and trading style.
Are Put Options Profitable?
All trading styles have the potential to be profitable — and they all come with risk. But like the methods I teach for penny stock trading, you must find a system and follow a set of rules.
I’ve covered the basics of buying and selling put options. You now know how to profit. If you’re a buyer, the price must decline. If you’re a seller, the price needs to stay above the strike price.
The risks often outweigh the rewards. It’s important in all trading — whether penny stocks or options — to only take the best setups.
Always make sure you use proper risk/reward no matter what you trade.
Understanding Put Options Charts
Although some do actually chart the price of options over time, we won’t get into that today. Know that in general, the premium of put options and call options decrease over time.
You want to pay attention to the bid and the ask. These work the same as stocks. But the spread can be quite large as you can see in this TSLA example.
The premium spread can vary by 10%–30% or more. This is a huge gap when you compare it to stocks for which a spread of 1%–2% is considered large.
This put options chart shows that there’s a clear significant risk to trading options. Understand the basics of buying and sell stocks before you start making bets on their future moves.
The Bottom Line
I don’t like to try to predict. My trading style is to react to the price action. No one in history has been able to predict the future consistently over time.
I’ve been trading for over 20 years. My best trades come from reacting to price — not predicting it.
So if you do decide to trade options, just know that you are playing a whole new ball game with a completely different set of rules you’ll have to learn.
Editor, Penny Stock Millionaires