You’re probably buying puts because you want to mitigate risk or hedge a long position. Sure, it might make sense most of the time, but there are certain market scenarios where it just doesn’t make sense.
So if you find yourself in any of these three scenarios, take some time to really consider if buying puts is the best option for you.
Implied Volality Levels Have Exploded and are at the top end of their recent or historical range
Just because implied volatility has moved to the top end of its range, doesn’t mean it can’t go higher. If you’re looking to hedge a position or are trying to reduce risk, a put purchase might still make sense. That being said, it’s also important to keep in mind that IV levels have a tendency to revert to the mean. If you buy an overinflated put option as a speculative play, you could see that put’s value decline swiftly and sharply if IV levels start to decline.
The Underlying Market Has Already Seen a Steep Decline
While a market can technically decline to zero, one that has already seen a substantial decline may not be the best bet for buying speculative puts. For example, if a share loses 50 percent of their value, you have to consider the possibility of a retracement and back-and-fill trade. If or when shorts start to cover positions, the stock could see a swift and powerful rally that could potentially erode put option premiums quickly.
When the Market has Reached a Long-Term Support Level
While there is nothing to say that the market won’t break support and head lower, long-term key support levels could potentially hold and act as reversal points. For example, if a strong stock declines to its 200 day moving average, buyers could step in fueling short covering and a market reversal, leaving put buyers holding options that may expire worthless. In such a case, you may want to consider looking for a clean break of support before buying put options to try to avoid buying puts just before possible reversals.
Buying put options may still make sense even in the above scenarios based on numerous factors. It is important to remember, however, that speculative trading is a game of odds and you always want to try to tilt the odds in your favor as much as possible.
