The stock market offers various ways to make money. From the classic "buy low, sell high" method to short selling and trading options contracts, there are diverse strategies.
Among experienced traders, two favored options strategies are put spreads and naked puts. Before understanding these, get familiar with options trading to see if one fits your investment plan.
An options contract lets its owner buy or sell a fixed security at a set price within a certain time. It also helps investors manage risk in their portfolio. Typically, each options contract covers up to 100 shares of the asset.
According to Emmet Savage, CEO of MyWallSt, options differ from long-term investing because they have an expiry date. Predicting a company's future and guessing if the market will agree by a specific date are separate skills.
There are two types of options—calls and puts—that investors can buy or sell in the market.
Options contracts involve a premium, which is the price the contract buyer pays to cover the risk for the contract seller.
Investors gain by buying a call option when they think the asset's value will go up.
For instance, let's say ABC stock is ₹100 per share, and you predict it will reach ₹115 soon. You decide to buy a call option for ₹5 per share.
How does this call option help you profit? If ABC stock reaches ₹115, according to the options contract, you can buy 100 shares for ₹10,000 (₹100 x 100 shares). You paid ₹500 for the option (₹5 x 100 shares). You'll own shares worth ₹11,500 but only paid ₹10,500, making an instant profit of ₹10 per share (₹115 - ₹100 - ₹5 = ₹10).
Investors benefit from buying a put option when they expect the stock to drop.
For instance, if XYZ stock is at ₹100 per share and you think it'll go down to ₹85 soon, you might buy a put option for ₹5 per share.
How does this put option help you make money? If XYZ stock falls to ₹85, based on the options contract, you can buy 100 shares for ₹8,500 (₹85 x 100 shares). You paid ₹500 for the option (₹5 x 100 shares). Then, selling those shares at ₹100 each as per the contract earns you a ₹10 profit per share.
Investors also benefit from options contracts by selling them. When someone sells an options contract, they earn money from the premium they receive for selling the contract.
When someone sells an options contract, it's also known as writing an options contract.
For instance, if you buy a contract for 100 shares at a premium of ₹2.20 per share, you'll pay ₹220 for the contract. The seller earns that ₹220 by selling the contract.
A naked put is when someone sells a put contract without owning any offsetting positions. You can sell a put option even if you don’t already have short positions of the stock. Sellers of naked puts make money from the options contract if the stock price goes up.
The most they can gain from naked puts is the premium they get for selling the option contract. But there's a big risk since theoretically, if the stock price drops to zero, the seller might have to buy worthless stock at the strike price.
On the flip side, a covered put involves having a short position in the underlying stock when you sell the put contract. For instance, selling a put contract on a stock like EFG while also having at least 100 shares of EFG as a hedge for your position.
A put spread is an options strategy where investors both buy and sell the same quantity of put options at once to protect their positions.
For instance, someone might use a put spread strategy by selling a put option of ABC stock and buying another put option of ABC stock simultaneously. If their bought put option doesn't work out, they limit potential losses because they've sold another put option on the same stock at the same time.
There are bullish and bearish strategies using put spreads, where you buy and sell put options on the same stock at the same time to manage risk.
Bullish put spreads involve selling a put option with a higher strike price and, at the same time, buying a put contract at a slightly lower strike price. This lets you earn money from the premium if the stock price goes up. If the stock price drops, buying a put contract helps limit potential losses from the sold put option.
Bearish put spreads involve buying a put contract with a higher strike price and, at the same time, selling a put option at a slightly lower strike price. This could make you money if the stock price falls. If the stock price rises, selling a put option offsets potential losses from the purchased put contract.
In both bullish and bearish put spreads, you're minimizing the possible losses by using a put contract that earns profits if your main strategy doesn't work as expected.
Deciding between naked puts and put spreads relies on your comfort level with risk in your investment plan. Naked puts offer greater risk but the chance for higher profits. Put spreads are a bit safer but may yield slightly lower returns.
These methods aren't suitable for every investor and might suit those with more trading know-how. If you’re keen on these strategies, assess your portfolio’s risk, match it with your investment goals, and then pick the trading strategy that suits both.
Buying an options contract isn't like buying company stock. It's a deal to buy stock at a set price within a specific time. Naked puts and put spreads are strategies in options trading that can aid investors in managing their positions.
Options trading has advantages, yet it comes with risks. New investors might benefit from seeking advice before diving into options. The strategy you pick depends on how much risk you're okay with and your overall portfolio goals.
