Most people tend to focus on making gains only when the stock market’s moving higher… But the most experienced and seasoned traders know they can trade both sides of the market.
Keep in mind that stocks usually fall three-times faster than they rise, giving us tremendous trade opportunities to play both sides, decreasing our overall risk over time.
But that also takes knowing how to choose the right put option…
How to Choose the Right Put Option to Purchase
When picking a put option to buy, the plan is to gain when the underlying asset falls in price. It’s the exact opposite of a call option, which rises in value when the underlying moves higher.
And the more the price falls, the more value a put option has.
During prolonged bear market cycles when stocks keep falling, knowing how to choose the right put option is a great tool.
For example, if you believe earnings are going to cause one of your current positions to fall in price, buying a put option can protect or mitigate downside selling pressure.
Now, that’s if earnings are below expectations during a particular earnings quarter.
Like to call options, you don’t have to own the underlying asset to benefit.
So instead of shorting or selling assets short that you don’t own, you can purchase a put option.
This can result in less risk to your account than selling the actual underlying asset instead.
When you buy a put option, you know in advance how much you can lose — the premium paid to buy it.
But when you short the underlying asset instead, you don’t know your actual risk unless you use buy-stop orders (or stop-loss orders for short traders).
And even then, an overnight gap or sudden news can cause the asset to gap above the buy-stop price, increasing your intended risk on the trade by an unknown amount.
How to Choose the Right Put Option: 1 Popular Method
One popular put option method is to initiate a long put position as a hedge, or protection against strong downside moves that can impact your existing trades.
That means you can purchase puts instead of liquidating or protecting your account using stop loss-orders.
While the mitigation may not result in 100% protection, it can help you avoid liquidating the actual asset and protect your portfolio as a whole.
It could also help you keep part of your portfolio safe by purchasing puts to protect only the assets that are at risk at any given time.
The best type of market environment for a put buyer is one that’s about to fall in value.
So in essence, you have to start thinking like a short seller to benefit from long put options.
How to Choose the Right Put Option: Technical Indicators
There are several technical indicators I use to help me trade to the short side or benefit in a bearish market.
One of the best indicators to use when learning how to choose the right put option is to scan for assets making 90-day price lows.
According to extensive back tests, assets that trade at the 90-day price low tend to continue moving lower over time.
I suggest you create a weekly list of stocks that meet this criteria and combine it with a short-term technical indicator you can use to fade against the main downtrend.
In the example below, you can see the stock trading lower over time. You always want to trade in the direction of the main trend, so the first step is to make sure the asset is moving lower over time.
The biggest mistake you can make when learning how to choose the right put option is to trade against the main trend.
Avoiding this one mistake can make a big difference in your trading.
Once you identify the main trend, wait for the asset to reach a 90-day price low or break below it.
The next step is to wait for a pullback against the main trend and the 90-day price low.
You can use one of several short-term technical indicators, or a set-up based on a price pattern to help you identify the pullback against the main trend to find the best time to buy a put option.
You’ll want to buy the put option before the asset reverts back to the main trend, which will most likely be the outcome from a statistical perspective… and from my experience over the past two decades trading both sides of the market.
The 3 Types of Put Options
There are three different types of put options. Each one has a distinct advantage and disadvantage: at the money, in the money and out of the money.
So that’s another factor we have to take into account when learning how to choose the right put option.
A put option is at the money if the strike price of the option and price of the underlying asset are at the same price level.
For example, if XYZ stock is priced at $50 per share and you buy a put option with a strike price of $50, the option would be at the money.
On the other hand, if the strike price was at $60 and the price of the underlying asset was at $50, the put option would be in the money.
And if the strike price was $40 and the underlying asset was at $50, the put option would be out of the money.
The most expensive put option is one that’s in the money because in addition to time value, the option also holds intrinsic value… which in addition to time value, is the second biggest factor that determines the price of the option.
For those of you wondering, volatility is the first.
As the strike price moves from being in the money to at the money, the price of the option falls because the option doesn’t have intrinsic value.
But because the option is on the verge of being in the money, the price of the option is lower than the in-the-money option.
The out of the money put option costs the least because the strike price of the option is below the price of the underlying asset.
This type of put option holds no intrinsic value and has the least chance of ending up in the money at expiration.
You have to keep in mind that the market price of an option at any given time is based on the odds of that option expiring in the money.
Therefore, the closer the put option gets to being in the money, the more it’ll be worth. And the further it gets from being in the money, the less it’ll be worth.
How close or far away you choose to buy a put option should be determined by the type of price move you expect from the underlying asset.
If you expect a small to moderate price move, an in-the-money option might be the best choice because the underlying asset needs to move moderately lower for the price of the put option that’s in the money to increase.
If you expect the price of the asset to fall sharply over a short period of time, then an out-of-the-money put option may be the best choice since it’ll offer you the most leverage under the circumstances — and cost less up-front premium.
Keep in mind that from a perspective of probabilities, the odds favor options that are in the money over out of the money because put options that are in the money have a much higher chance of ending up profitable prior to expiration.
When deciding which option to purchase, always take into account the worst-case scenario — that you can lose all of the premium invested — as well as the potential upside.
Learning how to choose the right put option can be tricky.
But with time and actual trading experience, you’ll begin to develop a natural feel for different options and how they react to the underlying asset.
If you’d like to learn more about trading options, check out: Learn to Swing Trade Options With This Beginner-Friendly Strategy and How to Choose the Right Call Option.
And if you haven’t done so already, subscribe to our YouTube channel so you can be notified as soon as we make our next post, and see what trade opportunities we’re paying close attention to!
All the best,
Roger Scott
Senior Strategist, WealthPress
