A first option trade– buying a put option

Options are powerful financial tools that can deliver desired outcomes, but require understanding and careful use. Options are not suitable for everyone. One of the challenges for newer option traders is understanding the risks and rewards of option trading, and becoming familiar with placing option orders and monitoring positions.

A lower risk way to start an options trading journey is to “paper trade” options. In both the moomoo app and on the desktop trading platform the paper trading modules allow investors to select their option and enter a trade, watch its performance and close the trade, all in a practice session without financial risk. Once an investor is familiar with the mechanics of option trading, they can move onto trading real money.

One important quality of options is that if an investor or trader only buys options to open a position, the amount at risk is the cost of the option. The investor cannot lose more on the option position than the amount spent on the option.

That’s why a purchase of a put option is sometimes a first options trade. Put options increase in value as a stock or index falls. An investor who believes a share price will fall in the near future can profit from owning put options, if their view is correct. If the view is incorrect, the amount at risk is the money spent on the put option.

This is why investors use put options to hedge their portfolios. An investor who believes that a stock they hold may fall but doesn’t want to sell that stock, can buy a put option over that stock, or the market index. If the stock and the market fall, losses on the stock portfolio can be offset by gains on put options. An investor may even profit from a fall in the stock they own, depending on factors like how many puts the investor buys and how far markets fall.

Here’s a scenario:

It’s 3 September, and Irene Investor is holding a portfolio of US tech stocks. She has holdings in 5 stocks, with a portfolio value of US $800,000. Irene is concerned that the jobs data that will be released on Friday will be a lot stronger than forecast, pushing back any potential interest rate reductions and rattling investors’ nerves. She’s worried a change in the market thinking could start a big selldown of US shares.

Irene decides she will buy a put option over the Nasdaq 100 index to offset potential losses in her portfolio.

Going to the Markets/Options tab in the app, or the Custom/Options Trader page on the platform, Irene selects the NDX, or Nasdaq 100 index. Another way is to use the search bar to find NDX or Nasdaq 100, and then select the options tab. The option Chains displays a filterable list of options for consideration.

Irene then uses the filters to select the put option she wants. She is covering a specific event, so she selects an expiry of 12 September, a week beyond the jobs data release. The NDX is trading just above 23,600, and Irene wants to hedge in the event of a large selldown, so she selects a put with a strike price of 23,000. This means that if the NDX closes below 23,000 on 12 September, Irene will receive a cash payment. The further the NDX is below the strike price, the more cash Irene will receive.

The contract multiplier for these index options is 100.  The Sep 12 NDX 23,000 Put is offered at 70 points, so the cost of the put purchase is:

1 contract x 100 x 70 points = $7,000

If Irene’s forecast is wrong, and the share market is steady or higher by 12 Sep, she will lose the $7,000 paid in premium for the put option, just as a homeowner who insures their house will lose the insurance premium if the house does not burn down.

The worst case under this scenario is that some or all of Irene’s stocks drop in value, and the index falls only slightly and expires above 23,000. In this case, she would lose money on her stocks and the $7,000 premium.

However if Irene is correct and the market falls hard, she will likely benefit. If both her stocks and the index fall 10%, she will lose $80,000 on her portfolio, but gain on the put position:

(23,000 – 21,240) x 1 contract x 100 = $176,000

Irene is paid the difference between the strike price of the put option and the closing price of the NDX on 12 Sep (21,240), multiplied by the number of contracts (1) and the contract multiplier of 100.

Irene’s portfolio may fall by more or less than the index, but if they fall broadly in line she will be in profit by around $96,000. If her portfolio falls more than the index, she will make less or even take a loss. If the portfolio falls less than the index, Irene’s profit will be larger.

A put option is “in-the-money” if the share price is lower than the exercise price (strike price) of the option. If the option is in-the-money at expiry, an index option will be automatically exercised and the cash difference paid to the buyer of the put option.

The above only applies to put options over an index like the NDX or SPX. Put options over stocks and ETFs are different. Exercising a put option over a stock will cause the buyer of the put option to sell that stock at the exercise price of the put option.

Use the Learn centre to read and understand the basics of options:

Make sure there is an understanding of the Terms and Conditions expressed in the PDS:

Enable account for options trading (levels 1-4)

Practise and familiarise through paper trading

For serious traders, enable real-time quotes.

Do you use put options for trading and investing? Tell us what works, and what doesn’t, below.