Buy A Put

A trader who thinks that a stock will go down can buy the right to sell the stock (a put option) at a set price. If the stock price at expiration is below the strike price by more than the premium paid, then he will make a profit. If the stock price at expiration is higher than the strike price, then he can let the option expire worthless, and lose only the amount of the premium paid.

Example

Suppose MSFT is trading at $46. A put option with a strike price of $46 expiring in a month is priced at $1. A trader’s assumption is that MSFT will decrease sharply in the coming weeks and so he pays $100 to purchase a single $46 MSFT put option covering 100 shares ($1 x 100 = $100) expiring in 30 days.

If his assumption is correct, and the price of MSFT stock goes down to $40 at option expiration, then he could exercise the put option and sell 100 shares of MSFT at $46. By selling the shares immediately in the open market at $46, the total amount he will profit from the exercise is $6 per share ($46 - $40). As each option contract gives the right to buy 100 shares, the total amount he would receive when he sells the shares is $6 x 100 = $600. Since he paid $100 to buy the call option, his net profit for the entire trade is $500 ($600 - $100).

If his assumption is incorrect and the price of MSFT rallies to $50, then the call option will expire worthless and the total loss of the trade is limited to the $100 paid to purchase the option.

Profit and Loss (P&L) at Expiration

The risk in a long put strategy is limited to the price paid for the put option no matter how high the stock price trades on the expiration date.