It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using a product that is most often associated with gaining from falling prices. However, as you'll see with the two methods below, it is possible.
A put option gives the purchaser the right to sell the underlying at the agreed upon strike price, regardless of how far the price declines. For this right, the trader pays a premium, which in turn is kept by the writer of the option if the price of the asset closes above the strike price at expiration. Looking at this transaction from the perspective of the option writer rather than that of the purchaser, it becomes apparent that when an option trader has a bullish outlook on a security, he or she can collect a premium by selling put options and keep the premium when the options expire worthless.
The downside to using this strategy is the amount of risk associated with holding a short position in a put option. Therefore, this strategy should only be attempted by traders who understand all the risks, so that the likelihood of significant losses is reduced. (To learn more about this strategy, see Introduction To Put Writing.)
One method of avoiding the risk associated with a short put option is to implement a strategy known as a bull put spread. This strategy is created by selling one put option and buying another with a lower strike price. In this case, the lower put option protects the trader from large declines in the price of the underlying because the gains from a move below the strike help offset the losses the trader incurs when the original holder of the long position exercises his or her options. This strategy also has a limited profit potential equal to the difference between the amount collected from selling the option and the price paid to acquire the other option. Profiting from an increase in the price of an underlying asset by using a product that is associated with declining prices may seem attractive, but it is extremely important that you have a good understanding of the risks and payoffs associated with both of these strategies before you incorporate them into your trading.
For further reading on put options, see Trading The QQQQ With In-The-Money Put Spreads.
- After exercising a put option, can I still hold my option contract in order to sell it at a lower price?
- Are Stocks With Large Daily Volume Less Volatile?
- Are We In A Bull Market Or A Bear Market?
- Can a stock lose all its value? How would this affect a long or short position?
- Can a stop-loss order protect a short sale?