Put Option Explained

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Put Option

What Is a Put Option?

A put option is a contract giving the owner the right, but not the obligation, to sell, or sell short, a specified amount of an underlying security at a pre-determined price within a specified time frame. The pre-determined price the put option buyer can sell at is called the strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put can be contrasted with a call option, which gives the holder to buy the underlying at a specified price on or before expiration. They are key to understanding when choosing whether to perform a straddle or a strangle.

Key Takeaways

  • Puts give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame.
  • Put options are available on a wide range of assets, including stocks, indexes, commodities, and currencies.
  • Put option prices are affected by the underlying asset price and time decay. They increase in value as the underlying asset falls in price, and lose value as time to expiration nears.

Put Option Basics

How Do Put Options Work?

A put option becomes more valuable as the price of the underlying stock decreases. Conversely, a put option loses its value as the underlying stock increases. Because put options, when exercised, provide a short position in the underlying asset, they are used for hedging purposes or to speculate on downside price action.

Investors often use put options in a risk-management strategy known as a protective put. This strategy is used as a form of investment insurance to ensure that losses in the underlying asset do not exceed a certain amount, namely the strike price.

In general, the value of a put option decreases as its time to expiration approaches due to time decay, because the probability of the stock falling below the specified strike price decreases. When an option loses its time value, the intrinsic value is left over, which is equivalent to the difference between the strike price less the underlying stock price. If an option has intrinsic value, it is in the money (ITM).

Out of the money (OTM) and at the money (ATM) put options have no intrinsic value because there would be no benefit of exercising the option. Investors could short sell the stock at the current higher market price, rather than exercising an out of the money put option at an undesirable strike price.

Time value, or extrinsic value, is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires. Different put options on the same underlying asset may be combined to form put spreads.

The payoff of a put option at expiration is depicted in the image below:

Where to Trade Options

Put options, as well as many other types of options, are traded through brokerages. Some brokers have specialized features and benefits for options traders. Those who have an interest in options trading can check out Investopedia’s list of best brokers for options trading. There you can get an idea of which brokers may fit your investment needs.

Alternatives to Exercising a Put Option

The put seller, known as the “writer”, does not need to hold an option until expiration, and neither does the option buyer. As the underlying stock price moves, the premium of the option will change to reflect the recent underlying price movements. The option buyer can sell their option and either minimize loss or realize a profit depending on how the price of the option has changed since they bought it.

Similarly, the option writer can do the same thing. If the underlying’s price is above the strike price they may do nothing because the option may expire worthless and they can keep the whole premium. But if the underlying’s price is approaching or dropping below the strike price, to avoid a big loss the option writer may simply buy the option back, getting them out of the position. The profit or loss is the difference between the premium collected and premium paid to get out of the position.

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Real World Examples of Put Options

Assume an investor owns one put option on the SPDR S&P 500 ETF (SPY)—currently trading at $277.00—with a strike price of $260 expiring in one month. For this option they paid a premium of $0.72, or $72 ($0.72 x 100 shares).

The investor has the right to sell 100 shares of XYZ at a price of $260 until the expiration date in one month, which is usually the third Friday of the month, though it can be weekly.

If shares of SPY fall to $250 and the investor exercises the option, the investor could establish a short sell position in SPY as if it were initiated from a price of $260 per share. Alternatively, the investor could purchase 100 shares of SPY for $250 in the market and sell the shares to the option’s writer for $260 each. Consequently, the investor would make $1,000 (100 x ($260-$250)) on the put option, less the $72 cost they paid for the option. Net profit is $1,000 – $72 = $928, less any commission costs. The maximum loss on the trade is limited to the premium paid, or $72. The maximum profit is attained if SPY falls to $0.

Contrary to a long put option, a short or written put option obligates an investor to take delivery, or purchase shares, of the underlying stock.

Assume an investor is bullish on SPY, which is currently trading at $277, and does not believe it will fall below $260 over the next two months. The investor could collect a premium of $0.72 (x 100 shares) by writing one put option on SPY with a strike price of $260.

The option writer would collect a total of $72 ($0.72 x 100). If SPY stays above the $260 strike price, the investor would keep the premium collected since the options would expire out of the money and be worthless. This is the maximum profit on the trade: $72, or the premium collected.

Conversely, if SPY moves below $260, the investor is on on the hook for purchasing 100 shares at $260, even if the stock falls to $250, or $200, or lower. No matter how far the stock falls, the put option writer is liable for purchasing shares at $260, meaning they face theoretical risk of $260 per share, or $26,000 per contract ($260 x 100 shares) if the underlying stock falls to zero.

What is an Option? Put Option and Call Option Explained

The Chicago Board Options Exchange defines an “option” as follows: There are many ways a stockbroker can violate legal and ethical obligations to a customer, and in most cases, the broker’s

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

For most casual investors, that definition may as well be written in ancient Greek. And yet brokers sometimes buy and sell options for investors who don’t understand what they are, can’t appreciate or afford their risk, and may not even know that the option transactions are occurring.

Put Options and Call Options

Perhaps we can explain options a bit more clearly.

There are only two kinds of options: “put” options and “call” options. You’re likely to hear these referred to as “puts” and “calls.” One option contract controls 100 shares of stock, but you can buy or sell as many contracts as you want.

Call Options

When you buy a call option, you’re buying the right to purchase from the seller of that option 100 shares of a particular stock at a predetermined price, which is called the “strike price.” You have to exercise your call by a certain date or it expires. To purchase a call option, you pay the seller of the call a fee, known as a “premium.” When you hold a call option, you hope the market price of the stock associated with it will increase in the near future. Why? If the stock price increases enough to exceed the strike price, you can exercise your call and buy that stock from the call’s seller at the strike price, or in other words, at a price below the stock’s market value. Then you can either keep the shares (which you obtained at a bargain price) or sell them for a profit. But what happens if the price of the stock goes down, rather than up? You let the call option expire and your loss is limited to the cost of the premium.

Put Options

When you buy a put option, you’re buying the right to force the person who sells you the put to purchase 100 shares of a particular stock from you at the strike price. When you hold put options, you want the stock price to drop below the strike price. If it does, the seller of the put will have to buy shares from you at the strike price, which will be higher than the market price. Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your shares losing too much value. If the market price instead goes up rather than down, your shares will have increased in value and you can simply let the option expire because all you’ll lose is the cost of the premium you paid for the put.

Purchasing options can give you a hedge against losses, and in that sense, they can be used conservatively. But there are many options strategies that amount to little more than gambling and can increase your risk to a frightening degree. One simple example is the sale of “uncovered” calls. Remember, when a call is exercised, stock must be delivered by the seller of the call. If you’ve sold that call on stock you already own, the call is “covered” by those shares and your cost has already been incurred. If the option is exercised, you’ll simply deliver those shares to the option holder. But if you sell an “uncovered” call, meaning you don’t yet own the stock, your potential for loss is unlimited. If the option is exercised, you’ll have to buy those shares on the open market to cover your obligation, no matter how high the price may be at that time. If a strong market advance or a major announcement by the issuer has driven the share price up sharply, your losses could be enormous.

As indicated, many option strategies involve great complexity and risk. For this reason, not all options strategies will be suitable for all investors. In fact, with the exception of sophisticated, high net worth individuals who can afford and are willing to incur substantial losses, the writing of puts or uncovered calls would be unsuitable for just about everyone. Nevertheless, brokers sometimes engage in inappropriate options trading on behalf of customers who do not understand the risks.

If you have lost assets because your stockbroker was engaging in options trading, please contact us today.

Put Option

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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