To The Moon

This is part 3 of Demystifying Options... If you are not familiar with options, I would suggest reading my first two post:

Demystifying Options Part 1 - Introduction to options

Demystifying Options Part 2 - Selling Put options

A short recap on the types of options available...

There are 2 types of options - Put option and Call option. You can buy and sell both of them.

This post will be discussing about BUYING put options.

When you BUY an option, you have to pay premium to the seller of the option.

You may have come across news articles or other posts saying that options give people the right to buy and sell shares. They are referring to buying options, NOT selling options.

Buying PUT options gives you the right to sell shares. You have the right to sell, but you do not have to sell if you do not want to.

In its most basic form, buying a PUT option protects against a drop in price of the shares. You can choose to buy PUT option if you have at least 100 shares of a company to hedge against a drop in price of the shares because each option contract is 100 shares.

However, buying PUT options are normally used by traders as part of a strategy to hedge against their trade.

Another type of trade that uses buy PUT is to short a stock indirectly.

The ONE RULE to take note of when buying put option is that you must be prepared to lose the entire premium you pay. That is also the maximum amount of money you will lose.

Let's use Tesla as an example company for all descriptions below.

Let's say you owned 100 shares of Tesla at $600 per share. You feel that the share price will rise, so you do not want to sell yet. However, you want to lock in your profit at $800 in case the share price suddenly crash to below $800.

Choice 1: You can set a stop loss limit at $800 dollars and hope that if the share price do drop, it will not drop so fast that you are unable to sell at $800. This is the most common and preferred practice.

Choice 2: You can buy a put option to hedge against this decline in the price. Note that all options have an expiry, so once it expires, you have to buy another put option again and pay the premium to continue this "protection". In the long run, this will not be profitable if the stock price does not crash, therefore this method is rarely used.

A more useful application of buying PUT option is hedging or protection as part of advanced option strategies which i will not discuss here OR shorting a stock indirectly.

Shorting a stock using buy PUT options

Shorting a stock is to speculate that the share price will drop. There are 2 ways to short a stock. You can short it directly, or you can short it using options.

You may have seen what happen to hedge funds when they short a stock directly (GME). In summary, they borrow shares from someone and sell them at market price. If the share price drop, they will buy back the shares from the market cheaper than they sell to return to the lender of the shares and earn the difference as profit. But, if the share price rises and the lender want their borrowed shares back, the hedge funds would have no choice but to buy back the shares from the market at a price higher than they sell to give back the shares to the lender, thus making a loss. The higher the share price goes up, the bigger the loss.

A less risky way is to short using options. You do not need to borrow shares if you use options, so you do not have that risk. You will instead profit from the option premiums by buying and selling option contracts.

The premium of an option is associated with the share price, the strike price, and expiry date (the duration of the contract).

- When the stock prices goes up, the PUT option premium will decrease.

- When the stock price goes down, the PUT option premium will increase.

If you speculate that the stock price will go down, you will buy PUT option at a strike price lower than the stock price and wait for the stock price to drop. Once the stock price drops, the option premium will increase. The bigger the drop, the higher the premium you will get. When the premium reaches an amount you are happy with, you will close (sell) your option contract and take profit. The difference in the premium you pay when you buy PUT option and the premium you will take back when you close (sell) your PUT option will be your profit.

If the stock price goes up instead, the premium will decrease and eventually goes to zero. In this situation, you will lose the entire premium you paid for the buy PUT option. This is the maximum loss and is capped at the premium you pay compared to shorting the stock directly where the loss can potentially be unlimited if the share price goes to the moon.

WARNING: Shorting a stock is very risky. Even though using options limited your loss, it is still a loss, so please understand the risks before you enter any trade.

Some terms that you might have come across:

OTM - Out of the money - For a put option, this is when the stock price is above the strike price of the option contract. For a call option, it is the other way round.

ITM - In the money - For a put option, this is when the stock price is below the strike price of the option contract. For a call option, it is the other way round.

ATM - At the money - For any type of option, this is when the stock price is exactly at the strike price (unlikely to be that accurate), so we normally take the nearest strike price to the stock price as ATM.

Note that if you are buying PUT options to short a stock or as part of advanced option strategies, you typically have to close (sell) your PUT option position before the option expiry.

If you wait till expiry, and the option is OTM or ATM, you will get nothing back (maximum loss) as the intrinsic value of the option is zero.

If the option contract is ITM on expiry, there is intrinsic value left, which is the strike price minus the stock price. In this situation, you will get back the intrinsic value.

When shorting a stock using buy PUT, the trader will close (sell) the PUT option contract once the desired profit is achieved as this gives better returns (there is both extrinsic value and intrinsic value) or when the trade is not going in the right direction to limit losses.

Note: Closing an option contract is DIFFERENT from exercising an option contract. To close a contract is to do the reverse action. In this post, we are talking about BUYING PUT option, so to close a BUY PUT, we will SELL PUT. On the tiger app, you can right click on the option position and select "Close" to make your life less complicated.

The process of buying put option for protection, hedging, or shorting a stock is similar to selling put options (using Tesla as example):

Step 1: Select an expiry date, the strike price you decide, enter the premium you want to pay, and the number of options to buy. This premium is for 1 share. The total premium will be multiplied by 100. Remember that you are BUYING PUT option, so click on BUY.

Step 2: The next screen is the confirmation screen of your buy put option. You can expand the order detail to see how much the commission and fees (Yellow underline) and the total premium you will pay. Note that the amount you pay will be the total amount PLUS the commission and fees.

Step 3: If a seller decides that the premium you want to pay is acceptable for the duration of the contract, he/she will take your premium and the contract becomes valid. Note that the premium is paid immediately, and not at the expiry of the contract.

Step 4: This step is important for shorting a stock as you would want to close out your position when the profit you want to make is achieved! If you are buying for protection/hedging, you will either leave it to expiry (protection) or close out the buy PUT position after you close out other positions (for hedging).

Step 5: On the day of expiry at market closing (if you leave it to expiry), 2 things can happen:

1) If the share price on the day of expiry at market closing is the same or above the strike price, the contract expires worthless. This means that you have "lost" the entire premium that you paid.

2) If the share price on the day of expiry at market close is the below the strike price, the contract gets exercised. Tiger will sell 100 shares of Tesla at the option strike price. Even if the share price is below the strike price, you will still be paid the strike price because you paid for the right to sell at strike price as per the option contract. Remember to subtract the premium you paid from the total profits of the sale. If you do not want to sell your shares, you must inform Tiger broker.

If you do not have 100 shares of Tesla, not to worry, you will be able to buy the shares directly from the market to sell it back to the seller. Since the market price is lower than your selling price, so you will profit from the trade.

Always remember.. If you do not understand what is happening, do not blindly follow and execute the trade!