There are many reasons why options contracts are good for a declining market. Here, we discuss insights when it comes to using options when it comes to slumping market environment.
Put Options Basics
A put option gives the buyer of that option the right to sell a stock at a predetermined price known as the option strike price. Buyers of put options are making bearish bets against the underlying company. The price you would have to pay for that put option will be determined, among other things, by the length of time you want the option to last. Longer time means higher payment.
When selling put options, the opposite is true. A seller of put options is taking on the obligation to buy the underlying stock at a predetermined price. Note the difference in buying and selling puts: when you buy a put, you simply have the right to sell the option.
If you don’t want to sell the stock at the option strike price since the shares are trading at a higher price, you can simply let the option expire and only lose out on the premium paid.
On the other hand, when you sell a put, you are required to buy the shares if the buyer of the put decides to sell them. So in selling put options, the risk is magnified only in the sense that you are entering into a contract where you have an obligation, not simply a right to buy the stock.
In Declining Markets
When the markets are declining, selling put options can be an excellent instrument even or the individual investor provided that the person understands how to sell puts wisely. When markets slip, they usually do so rather quickly leading to an increase in volatility, which in turn increases option premiums.
This makes sense because options are time-based instruments and having a stock price that moves quickly is what option traders want.
Obviously, selling options when there is more volatility implies that the sellers will get a higher price because of the increased premiums. While sophisticated option traders like to sell puts in hopes of getting the premium income, amateur traders should look at selling puts to make a way to buy shares in a business you like for a lower price.
Arguably, the best time to buy stocks is when the markets are declining. Yet many investors simply don’t have the emotional will to do so. Selling puts is one way to alleviate the problem.
Selling Puts Wisely
Since they are derivative instruments, the buying and selling of options should be undertaken with much care. Because the selling of a put firmly requires you to buy the underlying stock, you should only sell puts on businesses you know and would be 100 percent satisfied owning.
For the huge majority of investors, selling puts should only be considered as an outlet of owning shares down the road not as a method to gain additional income via premiums. You should let earning the option premium be a fallback in case you don’t get a chance to own the stocks for less.
An approach with this type of thinking will substantially diminish the probability of selling puts for the wrong reason and thus losing money.