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Success
in put buying primarily depends on your ability to
select stocks that will go down in price and to time
your selection fairly well. Most investment
strategies are designed to remove some of the risk
and exactness in stock picking, thus allowing you to
have some room for error and still make a profit.
But that doesn't exist with pure play put
buying.
Your
total investment could be lost in an option
play. It has to go down enough
and quickly enough to be profitable. For this
reason, one should only use risk money when buying
puts. The potential rewards in buying puts are very
attractive.
Illustration
of how a put purchase might work:
Assume
that ABC stock is selling at 52 and the 6-month put, the July 50, is selling for 3. With an
investment of $300, the put buyer may participate,
for 6 months, in a move downward in the price of the
stock. If ABC should drop in price by 10 points
(just over 20%), the July 50 put will be worth at
least $800 and the put buyer would have a 167%
profit on a move in the stock of just over 20%. This
is the leverage that attracts speculators to
options.
At expiration, if ABC is above 50, the buyer's loss
is total, but is limited to his initial investment
of $300, even if the stock rises substantially.
Although this risk is equal to 100% of his
investment, the dollar amount is still small. You
should never risk more than 15-20% of your risk
capital in call puts because of the high
percentage risks involved.
It
is very important to understand that the buyer of
puts will only make money if the price of the
underlying stock goes down.
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