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How Do Put Options Work?

By Motley Fool Staff – Updated Jul 18, 2017 at 1:10PM

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Puts can be an effective but risky way to profit from a bear market.

If you think the market is going to go down, one way to profit from that is to buy puts. These are stock options that give the holder the right to sell a specific stock, at a specific price, and within a specific timeframe in the future.

But buying puts isn't for the faint of heart. As analyst John Maxfield discusses with host Gaby Lapera in this week's episode of Industry Focus: Financials, investors will want to be careful before incorporating these types of instruments into their investing approach.

A full transcript follows the video.

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This video was recorded on July 10, 2017.

Gaby Lapera: listeners, we're having a theme week. It's been awhile since we've had one. This week's theme is Never Will I Ever, distinguished from never have I ever by intent, I suppose. It's fairly self-explanatory, but just in case, the idea is, we'll be talking about things that we'll never do or, on occasion, things that we'll never do again. Maxfield, I believe that you have volunteered to kick us off. Do you want to tell the audience what you never will you ever? That was awkward. [laughs] Never will I ever say that again.

Maxfield: Doesn't this remind you of college? It's like college, but a decade in the future, on a podcast.

Lapera: Yes. So, we will be very careful today, listeners. At least, we're going to try. If we say something to offend you, I'm so sorry.

Maxfield: OK, let me tell you what I will never. This is kind of a recent development for me. Let me walk you through this. Our listeners, our investors, I think they might find this interesting. And I've talked about this in the past on the show before, and I've written about it over the last few months. I have this general theory -- and I don't think it's my theory, at this point it's pretty common -- I think the market is really high right now. And here's why I think that. Two different reasons. First, look at the main valuation metric that people use to track stocks, it's the CAPE Schiller, there's a guy named Robert Schiller who's a professor of finance at Yale, he's done all this work on valuations in the stock market going back to the Civil War, a long time back. He's given us data that shows where the market level is at at any given point in time. And where it's at right now in terms of his valuation metric is, it's at the third highest level it's ever been at. 1929, it was a little bit higher. Maybe our listeners remember what happened in 1929. 1999, it was a little bit higher.

Lapera: And there was also a thing that listeners remember in 1999 as well. In and around that time. Just in case you think we're playing coy with you, that would be the Great Depression and the Dot-Com bubble.

Maxfield: Right, exactly. Here's the thing. Asset prices, particularly equity prices, are inversely correlated to interest rates. There's a reason that asset prices are really high right now, because interest rates are really low right now. So that needs to be taken into consideration. But even if you factor that in, the market is really high right now. I think it's hard to get around that fact. The second piece of this puzzle, though, is, there's this thing called the VIX, and the VIX tracks expected volatility in the stock market over the next 30 days, and it does that by looking at activity in the options market, puts and calls. This data is actually about a month old, the last time I looked at this. But if you go back to the beginning of the VIX it has traded below 10 on only 16 trading days. There could be four or five more now because a month has passed. But when I looked at it this month, there was only 16 trading days that it closed below 10.

Lapera: Why is that significant, though? Why is it significant that it has traded below 10?

Maxfield: I'll get to that. Half of those days -- and this goes back multiple decades -- eight of those trading days have been this year. So the question is, to your point, why is that significant? You look at what's going on in the world right now, you look at asset prices and equity prices, everybody knows that they're high. Yet there's no expected volatility in the market. You look at North Korea is testing ICBMs, which, you don't know where that's going to go. We have the issues with Russia and Europe. You have all these things going on in the world right now, and all this uncertainty in the United States, and all this uncertainty around potential catalysts that could cause stocks to either go up or down, whether it's tax reform or healthcare reform, whatever it is, all these things going on, yet at the same time, there's basically no expected volatility by professional traders. It just seems unusual. So, you add that to the fact that the market is really high, and you go back in history and look at when those two factors have lined up in the past, and those factors have lined up in the past. So, what that led me to believe is, generally, my investment approach is, I will contribute a certain amount of my income every year to my SEP-IRA, which allows you to contribute up to 25% of your income. Then, I'll way to invest that money until the opportunity in the market presents itself. The last time I did this was at the beginning of 2016, when we had a little correction in the market.

I was thinking, what I'll do is just wait, if this comes to fruition and the market recorrects at some point in the future, I'll just wait until that happens, I'll buy stocks cheap, and then I'll sit on those for a long time, which is generally what I do. But then I got to thinking about it. And I was like, why not just -- I've never tried to profit on the downside of anything. I'm in the investing business, I write about it, why not give it a try and see what's that like? So, what I did recently is bought some puts. The person who buys a put gives you the right to sell a stock at a certain price in the future. Let's say, with Bank of America, that's a company that I know well, the stock is trading around $24 a share. You could buy a put for whatever that would cost that would allow to sell that stock in two years at $24 a share. If Bank of America stock goes down to $20 in that time period, you can basically, for all intents and purposes, sell Bank of America for $24 and then buy it for $20 and then you profit on the downside. The problem with buying puts is, they expire after a certain time period. You can buy them out to two years, you can buy them out a month or two months or six months or a year, over all these different time periods, but the problem is, the price that you pay for that right decreases the closer you get to the so-called expiration date. Let's say I buy a put on Bank of America, thinking that its stock is going to go down, and I buy that put for a month out, the value that I pay for that put, as I get to that 29th day right before it expires is basically going to be nothing unless the actual stock has gone down far enough to actually make the put inherently valuable.

The lesson that I learned in all of this, in doing this, this is the first time I ever bought puts before, was that if you're going to try to buy puts to profit on the way down, you really have to have a good sense, or at least feel like you've gotten your thesis to a place where you have a sense that a catalyst is relatively imminent in the near future. Otherwise, it will cost you way too much to sit there and wait for the market to go down as the value of those puts erode.

Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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