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Options Before a Market Correction
The S&P 500 has been happily going up with one minor correction for five and a half years. Stocks are historically high priced. As always happens when a rally moves on to higher and higher prices, talk centers on when a market correction will happen, when and just how bad it will be. Our focus is on using options before a market correction in order to hedge risk and gain a little profit. We recently wrote about how to reduce investment risk with options. We suggest that if one had a stock that had gone up substantially it might be a good idea to purchase put options in order to protect your gains. In fact you do not need to own the stock in question in order to buy puts on a high flying stock.
Making Money with Put Options
A put option gives the buyer the right to sell a stock at a price set in the options contract. This price is called the strike price. The buyer pays a premium for this right. The buyer of an American option can execute the contract and sell the stock at any point during the course of the options contract. If the contract is a European style option the trader can only execute the contract at the end of the contract period. In each case the trader can simply execute the opposite trade and exit the contract, ideally with a profit. The buyer is never under any obligation to do so. The value of a put option is based on the strike price of the contract, the current market price of the stock, time remaining until expiration and market expectations. These last two factors are what are called the time value of the options contract. This value shrinks steadily as the contract period shortens. The first two factors are clear. If you purchased a $103 put option on XYZ Corp. this means that you can execute the contract and sell the stock for $103 a share. If your analysis is correct and the market corrected the stock may be selling for $103 a share. This makes the option worth $20 plus or minus time value. Buying put options before a market correction can be very lucrative. But when do you buy?
Timing an Options Trade
Two factors determine stock prices, fundamentals and market sentiment. Today the fundamentals indicate that perhaps prices are a little too high. But if the sentiment of the market is that there are no better places to put your money than in the rising US stock market maybe market sentiment wins and the market keeps going up. Successful options trading is a combination of knowing the fundamentals that eventually determine stock price and having a good sense of what is motivating other traders and investors. So long as everyone thinks that the market is going up it will probably go up until some very dramatic economic even happens and then it will correct in a hurry. Here is where buying options before a market correction is profitable.