In our last article we showed you the pros and cons of buying calls as a directional trade on an underlying. Today we will take the other side and explore placing a downside directional trade using puts. As a put buyer you are making the exact opposite trade as a call buyer. You have a belief that the stock will decline in value.
Let's use the example from our last article, only this time we think XYZ has moved up too much and will now decline. XYZ's current price is $30. From here you can short shares and hope for a decline. This will reduce your buying power by $3000 for every 100 shares and you have a 50/50 chance that XYZ will decline. An alternate choice would be to buy the At-the-Money put (At-the-money is the strike price closest to the current price of the underlying). Let's say this put is trading for $0.90. Remember from our last article that this means you will be paying $90 for every one contract (one contract represents 100 shares).
Side note -- This is where people tend to get confused. As a put buyer you want the stock to decline. As the stock declines you will see a rise in the price of the put. Likewise, if the stock increases you will see a decline in the value of the put. Just remember that in this example you are the buyer. Most buyers of anything in life would like to see an increase in price after purchase. --
So let's assume XYZ moves higher and your assumption was incorrect. As a put buyer the most you can lose is what you paid for the put. So in our example your max loss is $90 per contract, whereas the trader who shorted the stock has an unlimited loss potential (theoretically if you are short stock it can go up forever). Now what if your assumption was correct? Well, unlike a call buyer who has unlimited profit potential, the put buyers' profits are technically limited. This is because the lowest a stock can go is $0. So we have to say the profit is technically "limited".
The pro's to put buying - Just like the call buying article, one of the pro's to buying a put is the limited capital requirement as compared to the short stock position ($90 compared to $3000 in our example). Risk is also a nice benefit to buying puts. Just like anything else in life, your risk is only limited to what you paid for the product.
The con's to put buying - As a buyer of any option you need the underlying asset to make a sharp and quick move in your direction. In today's example we would need XYZ to fall rapidly for us to make money. If it goes sideways, up, or takes a long time to decline we will likely lose money.