Put Options: How Time And Volatility Affect Your Option

Just like the stop loss order, put options are contingent on the assumption that share prices would fall.

When your goal is to effectively manage your portfolio, there are a few methods that you can employ – some of them helping you maximize profits, some to have a balanced portfolio, and others to mitigate risks when losses are expected.

Just like the stop-loss order, put options are contingent on the assumption that share prices would fall. A put option is a stock market tool that gives the owner the right but not the obligation to sell an asset or an underlying security at a specified price, by a predetermined date to a given party.

A put option, as such, is a bearish strategy. As an investor holding the security, you are considered to be hedging your investment when you have a put option. The only reason you would, therefore, buy a put option in the futures markets if you expect the underlying futures price to drop.

You have the option to sell the futures contract at the strike price any time before the contract expires. While this strategy, just like many others, is perfect theoretically, it has its flaws – some of it making it only idealistic. In the real world, it just might not work. More so, even when it does, the gains might just be too little.

The when is simple enough: When you expect a decline. For this, there are two principal factors to consider and they are time and volatility. These two factors are what affect the price of an option.

All things held constant, the further you go out it in time, the more expensive options become because of uncertainty. And as a result of the fact that our actions drive the stock market, a movement to purchase put options might further enhance the drop in price because the only reason you are getting a put option in the first place is because you expect the prices to fall.

A good example is where something negative happened in a company that makes its share price crash. It is a perfect reason to buy puts to hedge your position right? The thing is you wouldn’t be the only person making such a move – and since it is a panic move, the demand to purchase puts would drive the original market price up.

Investors who want to profit from the decline in price would now rush to purchase your option and this demand for it would further increase the price. What then happens is that the market would trade to a level that triggers a stop and then causes a reverse, allowing the investor to survive a volatile period that eventually returns to normal.

What this means is that the only way for you therefore maximize your leverage or even control your risk, is for you to have an idea of what type of move you expect from the futures market and make your decision in that manner. Luckily, options are options. You don’t have to follow through with them and that is what makes them relatively safe.

Written by Lawretta Egba.