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Buying Puts Option Strategy

When you are very bearish on the market, you can buy puts to profit from a downward movement that occurs while you own the option. Additionally, puts can be used to balance risk. If you are somewhat uncertain about the market, but you feel there is a possibility for a strong downturn, you can purchase a mixture of calls and puts to provide balance. Buy puts on overpriced options or options on overpriced assets. Buy calls on underpriced options or options on underpriced assets.

Puts can also be used for hedging purposes. They can provide insurance against a downturn in the assets you carry.

A put is the right, but not the obligation, to sell an asset at a specific price (the strike price), on or before a specific date (the expiration date).

For example, suppose XXX is presently trading at $77. per share. If you expect the price to decrease significantly over the next couple of months, you could purchase a put option to greatly leverage your profits from the expected movement. Suppose that at current prices, you could purchase a put on XXX with a strike price of $80 and an expiration date a couple months out for about $7.00. If you are correct and XXX trades at $65. during the couple months while you are holding the option, the price of your option will more than double during that time period because the option will be priced at least $15. (anyone holding that option has the right to sell XXX at $80., but they can buy it at the current price of $65., yielding a $15. profit).

Although the underlying asset price decreased less than 16%, your put option on that asset increased by 100% or more. That's the leverage that options provide.

When you buy a put, your profit potential is unlimited. No matter how low the underlying asset price falls before expiration of your option, you reap the profits from that decrease. Yet, your risk is limited. If the underlying asset price rises by $20, the most you can lose is the price that you paid for the option. In the example above, if XXX rises to $97, the most you can lose is the price you paid. In this case it would be $7.00 per controlled share.

The person who sold you the option would absorb the rest of the loss.

When we purchase puts, we generally purchase them at-the- money or in-the-money, because it lowers our risk of losing the premium. Although out-of-the-money options are much cheaper and provide greater leverage, there is a greater risk of loss. We generally buy them several months out to provide enough time for the market to make the anticipated move.

Options are not like stocks where you buy them and hold them. Decay will continually erode your position and a change in trend can evaporate your profits quickly. It is important to set a specific target price for the option when you initiate the position. When we reach our target, we sell and take our profits. Beware that greed can be a strong motivator and make you want to increase your price target as it is rising. However, doing that can sometimes turn a winning position into a losing position.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

When you are analyzing potential option positions, it helps to have a computer program like Option-Aid that swiftly calculates volatility impacts, probabilities, statistics, and other parameters of interest. These programs can pay for themselves with the first trade that they help you with.

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