Stocks have been on a wild roller coaster ride recently. Earnings fears, worries about rising interest rates, concern over the end of Fed support, and euro zone fears have all conspired to drive the market lower. At the same time, most of the stock market internals remain bullish so savvy investors are diving in and buying stocks near the lows sending shares sharply higher in the process. Despite the roller coaster ride, the action has been text book for experienced investors.
This is particularly true for option traders. Option traders thrive on extreme volatility and that’s exactly what is happening.The fear and volatility measuring index called the VIX has spiked to historical average levels in the 20 zone. This is after several years of very low readings n the index.
This spiking VIX action has lifted prices on options across the board. Both put and call buyers have benefited from the elevated VIX readings.
While there still seems to be an equal number of bullish and bearish traders in the market, many traders both bullish and bearish are looking for ways to profit from the inevitable sell offs.
The most simple way option traders can profit from the sharp declines is to purchase put options.
While there are all kinds of different option strategies for a wide variety of stock market conditions, buying a put is the simplest way to profit from a decline. A put option is a bet that the stock or ETF will fall in price within a certain time frame. It climbs in price as the share price drops.
Buying a put limits your downside risk to the price you paid for the option. However, puts are very time sensitive. This means that not only does the underlying share price need to drop, it needs to drop within the lifespan of the put.
Most puts expire on a monthly basis and they all decrease in value as the time to expiration draws closer. Puts are highly effective tools for betting on a particular known event’s effect on price. If you believe that the earnings will be bad for a particular stock, buying puts to benefit from the anticipated price drop makes sense.
