Buying Tin Put Options to Profit from a Fall in Tin Prices

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Buying Tin Put Options to Profit from a Fall in Tin Prices

If you are bearish on tin, you can profit from a fall in tin price by buying (going long) tin put options.

Example: Long Tin Put Option

You observed that the near-month LME Tin futures contract is trading at the price of USD 11,550 per tonne. A LME Tin put option with the same expiration month and a nearby strike price of USD 12,000 is being priced at USD 770.00/ton. Since each underlying LME Tin futures contract represents 5 tonnes of tin, the premium you need to pay to own the put option is USD 3,850.

Assuming that by option expiration day, the price of the underlying tin futures has fallen by 15% and is now trading at USD 9,818 per tonne. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying tin futures at the strike price of USD 12,000. In other words, it also means that you get to sell 5 tonnes of tin at USD 12,000/ton on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying tin futures at the market price of USD 9,818 per tonne, resulting in a gain of USD 2,182/ton. Since each LME Tin put option covers 5 tonnes of tin, gain from the long put position is USD 10,910. Deducting the initial premium of USD 3,850 you paid to purchase the put option, your net profit from the long put strategy will come to USD 7,060.

Long Tin Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 12,000/ton – USD 9,818/ton) x 5 ton
= USD 10,910
Investment = Initial Premium Paid
= USD 3,850
Net Profit = Gain from Option Exercise – Investment
= USD 10,910 – USD 3,850
= USD 7,060
Return on Investment = 183%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the tin option sale will be equal to it’s intrinsic value.

Learn More About Tin Futures & Options Trading

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Prices Plunging? Buy a Put!

Investors may buy put options when they are concerned that the stock market will fall. That’s because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset heads southward. Therefore, if you own a put you will benefit from a down marketeither as a short speculator or as an investor hedging losses against a long position.

So, whether you own a portfolio of stocks, or you simply want to bet that the market will go down, you can benefit from buying a put option.

Key Takeaways

  • A put option gives the owner the right, but not the obligation, to sell the underlying asset at a specific price through a specific expiration date.
  • A protective put is used to hedge an existing position while a long put is used to speculate on a move lower in prices.
  • The price of a long put will vary depending on the price of the stock, the volatility of the stock, and the time left to expiration.
  • Long puts can be closed out by selling or by exercising the contract, but it rarely makes sense to exercise a contract that has time value remaining.

Prices Plunging? Buy A Put!

Speculative Long Puts vs. Protective Puts

If an investor is buying a put option to speculate on a move lower in the underlying asset, the investor is bearish and wants prices to fall. On the other hand, the protective put is used to hedge an existing stock or a portfolio. When establishing a protective put, the investor wants prices to move higher, but is buying puts as a form of insurance should stocks fall instead. If the market falls, the puts increase in value and offset losses from the portfolio.

Opening a long put position involves “buying to open” a put position. Brokers use this terminology because when buying puts, the investor is either buying to open a position or to close a (short put) position. Opening a position is self-explanatory, and closing a position simply means buying back puts that you had sold to open earlier.

Practical Considerations

Besides buying puts, another common strategy used to profit from falling share prices is to sell stock short. Short sellers borrow the shares from their broker and then sell the shares. If the price falls, the stock is bought back at the lower price and returned to the broker. The profit equals the sale price minus the purchase price.

In some cases, an investor can buy puts on stocks that cannot be found for short sales. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because the broker does not have enough shares to lend to people who would like to short them.

Importantly, not all stocks have listed options and so some stocks that are not available for shorting might not have puts either. In some cases, however, puts are useful because you can profit from the downside of a “non-shortable” stock. In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put, whereas the short seller is exposed to considerable risk as the stock moves higher.

Like all options, put options have premiums whose value will increase with greater volatility. Therefore, buying a put in a choppy or fearful market can be quite expensivethe cost of the downside protection may be higher than is worthwhile. Be sure to consider your costs and benefits before engaging in any trading strategy.

An Example: Puts at Work

Let’s consider stock ABC, which trades for $100 per share. Its one-month puts, which have a $95 strike price, trade for $3. An investor who thinks that the price of ABC shares are too high and due fall within the next month can buy the puts for $3. In such a case, the investor pays $300 ($3 option quote x 100, which is known as the multiplier and represents how many shares one option contract controls) for the put.

The breakeven point of a $95-strike long put (bought for $3) at expiration is $92 per share ($95 strike price minus the $3 premium). At that price, the stock can be bought in the market at $92 and sold through the exercise of the put at $95, for a profit of $3. The $3 covers the cost of the put and the trade is a wash.

Profits grow at prices below $92. If the stock falls to $80, for example, the profit is $12 ($95 strike – $80 per share – the $3 premium paid for the put = $12). The maximum loss of $3 per contract occurs at prices of $95 or higher because, at that point, the put expires worthless.

The distinction between a put and a call payoffs is important to remember. When dealing with long call options, profits are limitless because a stock can go up in value forever (in theory). However, a payoff for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95 because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0.

Close vs. Exercise

Closing out a long put position on stock involves either selling the put (sell to close) or exercising it. Let us assume that you are long the ABC puts from the previous example, and the current price on the stock is $90, so the puts now trade at $5. In this case, you can sell the puts for a profit of $200 ($500-$300).

Options on stocks can be exercised any time prior to expiration, but some contracts—like many index options—can only be exercised at expiration.

If you wished to exercise the put, you would go to the market and buy shares at $90. You would then sell (or put) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit, in this case, is also $200.

The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. This is known as the option’s time value. For example, if the stock is at $90 and the ABC $95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value. In this case, it is better to sell the put rather than exercise it because the additional 50 cents in time value is lost if the contract is closed through exercise.

Profiting From Falling Stock Prices

When buying stocks, falling market prices are your friend

Falling stock prices cause panic in some investors, but fluctuations in the market represent business as usual. Investors who are comfortable with this reality know how to hold their investments and how to recognize investments that are good purchases when stock prices are dropping.

Some keys to making a profit from an economic downturn are to ignore your panic mode, purchase stocks at reduced prices, or build a diversified portfolio which should include U.S. Treasuries, bonds, U.S. stocks, and foreign stocks (or funds).

Falling Stock Prices and Instincts

Human nature is to follow the crowd, and investors in the stock market are no different. If prices are going up, the kneejerk reaction might be to hurry up and buy before prices get too high. However, this often means that you’re rushing to buy a share of stock for $50 today that you could have purchased for $45 yesterday. When thinking about it that way, the purchase seems less attractive.

The opposite is also true. If prices are falling, people often rush to get out before prices fall too far. Again, this might mean that you’re selling a stock for $45 that was valued at $50 yesterday. Reacting in this manner does not help an investor make money.

Controlling your “flight” instincts will keep your long-term growth strategy intact.

While specific events or circumstances can cause stocks to spike or plummet and force investors to take quick action, the more common reality is that day-to-day fluctuations—even the ones that seem extreme—are just part of longer trends.

If you’re in the market primarily to build your nest egg (long-term growth), most often the best course of action is to do nothing and let the long-term growth take place. It is possible to make a profit from falling stock prices if you are quick, and purchase a stock for less than the price you can sell it for—but this can be tricky, and is more in line with the unreliable method of market timing (which is more similar to day-trading than investing).

Falling Stock Price Strategy

As you witness a sell-off of stocks because prices are dropping, you could take advantage of this situation by knowing in advance which companies you are going to invest in should prices begin to fall.

When You Should Buy Stocks

The time to look for investments to buy is not when stock prices drop—you should find these when the market is performing well. Look to identify companies that have weathered economic crises before, and purchase those stocks after prices have fallen.

Purchasing stocks when prices are lower generally leads to profits when the prices rise again—they always do. The market, economy, and stock prices all follow a cycle. In general, the market has been in a continuous climb for quite some time.

Over time, the market rebounds and prices rise again after falling. This has happened over and over, generally with an increase above previous prices.

The Standard & Poor’s 500 (S&P 500) index has climbed since it’s inception—when you look at a performance chart you can see the companies that make up the index have performed throughout many price avalanches.  

Other indexes you can look into are the Dow Jones Industrial Average, the Nasdaq, and the New York Stock Exchange (NYSE)—to name a few.

If Your Stock Prices Drop

What if the price of one of your stocks falls from $60 to $40? Although you are sitting on a substantial loss of more than 33% of the value of your holdings, you’ll be better off holding it in the long run for two reasons:

  1. If you reinvest your dividends to buy more stock, you increase your ownership in the company. Also, the dividends will purchase more shares at a reduced price. In other words, the further the stock price falls, the more ownership you can acquire through reinvested dividends
  2. If you have additional investment funds available, you might do well to buy more stock at lower prices. If you truly are focused on the long-term outlook, the short-term losses of stock price drops are less significant. 

Build A Portfolio For Falling Stock Prices

It has long been passed around the investing community that diversity helps to mitigate risks. Your portfolio should be built from a wide array of investment types. Stocks, mutual funds, index funds, bonds, and Treasuries all perform differently under different economic circumstances.

For example, Fidelity has built a few portfolio models that you can use as a guide for your portfolio. A balanced portfolio should have approximately 40% bonds, 35% U.S. stocks, 15% foreign stocks, and 10% short-term investments.  

This is simply an example. Every investor’s situation is different and each investor’s portfolio should reflect their tolerance for risk, financial abilities, and investing goals.

Your bond category should be made up of companies that have performed well over long periods of time, and U.S. Treasuries. The same criteria for choosing bonds from performing companies should be used to choose stocks—a good indication is a long run on the S&P 500 or another stock index.

Foreign Stocks and Short-Term Investments

Since many investors are hesitant to venture into foreign markets, there are plenty of foreign stock index funds from well-known financial companies such as Vanguard, who offers FTSE All-World ex-US Index Fund ETF Shares (VEU). Conduct some research and find some that you like for your portfolio.

Your short-term investments can take the form of certificates of deposit, short-term bonds, or money market accounts. Diversifying your portfolio in this manner mitigates risk by using all of the categories of investments to work against the poor performance of one or more of the other categories.

A Few Persistent Risks

While most long-term stockholders don’t need to fear sudden dips, there are a few risks that can cause serious issues.

It’s possible that if the company becomes undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. This is known as a hostile takeover, where the majority of shares are purchased and a person or party becomes the majority owner. This has a number of implications for investors, as sudden changes in management can affect market performance.

There are always risks when investing. Use diversification and monitor the companies you have invested in to ensure you mitigate the amount of risk you take on.

You might not have liquidity through your investments during a decline in stock prices. If you don’t have the cash to cover immediate expenses, you might have to sell shares at a significant loss. A good rule of thumb for avoiding this is to invest no more than 10% of your income or assets at any one time.

People tend to overestimate their skills and ability to estimate investment opportunities. The company you picked to invest in, or that was recommended to you, might not be as good a performer as you thought. Accounting skills, industry knowledge, and insights from friends—while great to have—are no match for investor sentiments, fear of loss, and panic.

Final Thoughts

As you navigate the roller coaster ride of investing, remember that a strategy (and sticking to it), a thorough analysis of prospective investments, and patience will help you make a profit from falling stock prices, and from the market in the long run.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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