Understanding the Value of Buying Higher Strike Puts

Introduction

Investors often encounter perplexing situations in options trading, especially when it comes to buying put options with strike prices that exceed the current trading price of a stock. A prime example is American Airlines (AAL), currently trading at $11.58, while a put option with a strike price of$20 is available, expiring in just 6 days. This raises a critical question: Why would someone willingly purchase such a put option?

What Is a Put Option?

Before diving into the rationale, it’s crucial to understand what a put option is. A put option gives the holder the right, but not the obligation, to sell a specific amount of an underlying asset at a predetermined price (the strike price) before a specified expiration date. Investors typically buy puts when they anticipate a decline in the stock price, as these instruments can provide substantial leverage and potential profits during bearish market movements.

Reasons to Buy a Higher Strike Put Option

1. Protective Strategy:
   One of the primary reasons for purchasing an out-of-the-money (OTM) put option, like the $20 put for AAL, is to hedge against potential losses on shares already owned. If an investor holds shares of AAL and fears a drop in value, buying a$20 put allows them to sell their shares at $20, minimizing losses in the case of a significant price decline. Thus, the put option acts much like insurance against adverse market conditions.

2. Speculative Moves:
   Investors might believe that upcoming market events can trigger a sharp decline in the stock price. This could relate to expected poor earnings reports, significant economic changes, or broader market corrections. By purchasing a put option with a higher strike price, the investor positions themselves to profit should their prediction come to fruition. For instance, if AAL drops to $5 before expiration, the put option allows the owner to sell at$20, yielding substantial gains.

3. Anticipating Volatility:
   High volatility can significantly influence the strategic buying of put options. If an investor expects AAL to experience considerable price swings, a high strike put may offer a better risk-to-reward ratio if they anticipate a downturn. Volatility can inflate option premiums, and AAL’s stock could drop rapidly, inverting market expectations.

4. Arbitrage Opportunities:
   Depending on market conditions, some traders attempt to exploit price discrepancies in options trading. If they perceive the $20 put as mispriced relative to the expected decline in AAL stock, they may choose to buy it, believing the put's value will increase as volatility rises or as the underlying stock declines.

Mathematical Perspective on Buying Higher Strike Puts

To further exemplify the value of a higher strike put option, let’s analyze a hypothetical scenario:

• Current Stock Price (AAL): $11.58
• Higher Strike Put Option Price: $20
• Cost of Put Option (Premium): Assume the premium cost for the $20 put is$0.50 per share.

If an investor buys 10 contracts (each contract represents 100 shares) for a total of 1,000 shares:

• Total Investment in Puts: 1,000 shares * $0.50 =$500

An essential aspect to highlight is the break-even point for this strategy. The break-even price at expiration is calculated as:

• Break-even Price = Strike Price - Premium Paid
• Break-even Price = $20 -$0.50 = $19.50

This means that if AAL shares are trading below $19.50 at expiration, the put option becomes profitable when exercised. In scenarios where the stock price dips below the sold shares price of$9.58 (i.e., buying puts ensures that investors can sell at a 20% premium over the current price), the investor effectively reduces their losses on the shares held.

Conclusion

In summary, while buying a put option with a higher strike price than the current trading price may seem counterintuitive, it can be a strategic move based on several factors such as protection from downside risk, market speculation, volatility expectations, or perceived mispricing in the options market. Investors need to understand their reasons for entering such positions and consider how tools like a trading journal can help track and analyze the effectiveness of their strategies. Ultimately, while purchasing puts can be a beneficial strategy, it is essential to be well-informed about the overall risk involved in options trading.

The Role of a Trading Journal

One practical way to enhance your options trading strategies is through trading journaling. Maintaining a trading journal helps investors evaluate past trades, understand their decision-making processes, and refine their strategies over time. WealthBee offers an excellent platform for traders to record their activities, analyze trends, and make data-driven decisions. Embracing a meticulous approach can contribute significantly to long-term investing success without giving direct financial advice or predictions.