Strategy talk: Think Twice before Buying Long Puts by Themselves If the market is forming something of a trading top here, you might be starting to look at buying puts. It is rarely justified, however, to buy long puts by themselves, and it is usually only justified after-the-fact when the underlying had a substantial and unexpected move downward. Naturally a sharp downward move in a stock that occurs fairly quickly can produce a profit from a reasonably-priced put option, but a number of factors work against buying long puts on a regular basis: • The cost of perpetual insurance from long puts is substantial. Taking AAPL as an example, the stock closed at 169.65 on Tuesday and the 30-day ATM put (170 strike) was selling at 4.70. That means there was 4.35 in time value. Taking that as an average amount of time value for 30 days of protection on the current price of APPL, over the course of a year, that would add up to 12 X 4.35, or 52.20, which is 30% of the price of the stock on an annualized basis. There are of course lower strike prices and longer time periods available, but this serves as a benchmark for seeing just how much it costs to protect a stock for continuous 30-day periods. • Dips tend to recover faster than advances retreat. Investors lean much more toward buying dips in equity prices than to selling advances. This comes from behavioral science as well as the training of investors and professionals to continually hunt for attractive prices to purchase. Humans also tend to overreact to perceived bargains. This makes it more difficult to make a profit from put options as the window of opportunity to take profits will be smaller than with calls. • By the time you decide to buy a put, the underlying has likely begun dropping and implied volatility is already likely elevated. This is especially true of situations where there are rumors of bad news or negative earnings. Buying puts when they are already elevated in price due to implied volatility simply adds to the cost mentioned above. • Put options price in dividends more than calls. Put prices anticipate upcoming dividends by increasing in price as the dividend approaches, while calls tend to hold value better. Buying puts can thus be paying in part for an anticipated dividend. • A put option is priced to address a move in its underlying from the strike price all the way to zero. But a trader is really only concerned about a small price drop most of the time. So, the long put by itself is paying for much more of a possible downward move than it needs to. Why not sell the risk below your target price to someone else? If you were playing AAPL to drop from 170 to 165 within a week and you bought the 170 put mentioned above, you would be paying 4.70 and receiving approximately 6.40 in 7 days if the stock were then 165. That would be a gain of 1.70/4.70 or 36%. If instead, you purchased a 170/165 bear put spread, you would be putting up around $2.00 and receiving around $3.05 in 7 days, for a gain of 52%. In addition, you would begin making profit sooner and would have a wider range of stock prices in a week that would generate a profit. This would all work the same way on an ETF such as SPY or QQQ. So, if you are thinking the market might roll over here and start correcting, restrain the urge to purchase an ATM put on either ETF. Instead, put on a bear put spread of some sort and then consider adding a credit call spread above the market to further reduce the cost of your position. Got a question or a comment? We're welcome your questions or feedback about the option strategies. If there is something you would like us to address, we're always open to your suggestions. By Richard Lehman, IVolatility.com
Put options price in dividends more than calls?? Calls hold their value better?? Perhaps you should refer to the strike relative to spot or Delta Are you implying a 10 delta put "prices in the div more than the corresponding 90 delta call?? What on earth do you mean by Put option pricing and the move in its underlying from its strike price all the way to zero.Thats like saying Call pricing and the move in its underlying all the way to infinity. Explain please before WXytrader polutes the thread with his BS model is BS
Lol what? I was just going to point out that pricing is based on standard deviation, not on the chance of it going to zero... but never mind.
I was gonna ask the same questions, but now I don’t need to type them PS. We should bookmark this thread for posterity
@taowave if you look at the near-term implied volatilities of puts vs. calls on a stock that is about to pay a dividend, you will often find that the IVs show as higher for puts. That is because the Black-Scholes formula does not consider dividends. So, unless the formula is adjusted for a dividend, the formula ignores the dividend when calculating theoretical value. That will make the put appear to have a higher IV than the call and can affect delta calculations as well. Your comment about calls being priced to infinity is actually correct. Option pricing theory has to use infinity as it cannot make a judgment on the highest possible price. That's why a put and a call at the same strike price will not be the same price when the stock trades exactly on that strike. The call will be slightly higher. The difference is small, perhaps to several decimal points, but it is there. The point is that a put will profit all the way to a stock price of zero (however unlikely) and that you can often benefit more from a bear put spread (which is designed to profit from a small but more likely decline) than a long put by itself, which can make more money from a more substantial decline in stock price but which rarely occurs. By Richard Lehman
I would hope one looks a model that accounts for the Div As for ATM calls over ATM puts,no mention of the foward or carry vs divs?