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Put Options Explained: What to Know to Get Started

W hile long-term stock ownership can lead to long-term profits, put options allow investors to control many shares without putting up the cash necessary. They can also help hedge or protect investments.

Investors buy put options if they expect the price of the underlying asset to fall within a specific time frame. Put options are typically good for 100 shares per contract. They’re bought and sold on underlying assets like stocks, bonds, commodities, currencies, futures, exchange-traded funds (ETFs), and indices.

Key Takeaways

  • Put option trading gives an investor the right to sell or short-sell securities at a set price and time. Holders of put options can profit from a drop in a security’s price.
  • Trading put options is a transaction between a seller or writer and the options buyer. Sellers receive a premium, and buyers receive the right to trade the underlying securities.
  • Alternatives to exercising put options include holding and repurchasing them.
  • There are four different strategies to profit from a bearish outlook on an investment: long put, short put, bear put spread, and protective put.

Put Options Explained

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Put options are contracts where holders can, but aren’t required, to sell or a set number of securities at a preset price and timeline. Put options are geared for underlying assets that investors expect to fall in value within a specific time frame and are bearish in nature. They are considered derivative investments, a type of investment with a value that is based on and moves along with the value of another financial product. This financial product is commonly referred to as the underlying asset.

Put options are available for numerous asset classes like stocks, currencies, bonds, commodities, futures, and indexes. They’re sold at a specified price, also known as the strike price. Put option holders have the ability to exercise the contracts but can decide not to use them.

Prices of put options are affected by fluctuations in the cost of the asset to which they’re connected, the strike price of the option, time decay (decline in value of options as they approach expiration), changes in interest rates, and market volatility.

  • Put options gain value as their underlying assets lose value, as volatility in the underlying asset’s value increases, and as interest rates fall.
  • Put options decrease in value as the underlying asset’s price increases, as volatility in the price of the underlying security declines, as interest rates go up, and as expiration dates loom. Investors can only use European-style options on the expiration date.

Time decay escalates as expiration dates near, as time runs out to see a return from the trade. As an option loses time value, only the intrinsic value is left. Intrinsic value is the difference between the strike price and the security’s current price. When an option holds intrinsic value, it’s said to be in the money (ITM). Options with no intrinsic value are known as out of the money (OTM) or at the money (ATM).

Time value, or extrinsic value, puts a value on the timing. Investors add that value to the intrinsic value. Time value recognizes that stock prices may fluctuate before the option’s expiry. Multiple put options on an asset can be merged to create put spreads.

When exercised, put options give investors a short position of ownership in the underlying security. Investors commonly use put options to hedge against losses or speculate on falling prices.

Investors incorporate put options into their strategy to keep their investments safe through a risk management technique known as a protective put. It ensures that losses in an investment do not fall beyond a set amount, the strike price.

How Do You Trade Put Options?

Deciding on trades for put options requires investors to consider many factors. Research the option contract’s value and potential for being profitable when looking into a trade, as the stock may fall beyond the point of being able to turn a profit.

Investors trade put options through brokerages, and some brokerages specialize in options trading. Choose a broker that matches your investment needs. Options are merely financial instruments. As such, they trade very similarly to stocks and bonds. However, purchasing put options is a bit different since they are a contract to buy the underlying securities instead of buying them outright.

Investors need to be approved by a brokerage based on standards that will categorize them into one out of four or five different classes. Investors can purchase options over-the-counter (OTC), which cuts out brokerages and is a direct purchase.

Options contracts usually control 100 shares and may have quarterly, monthly, or weekly dates of expiration. Time frames vary depending on the contract. Investors focus on the premium and the strike price for the option.

Put option sellers, also known as the option writers, receive the premium, which essentially operates like insurance. Writing print options generates revenue. However, the income is limited to the premium. Put buyers can continue to maximize profit until the underlying asset value goes to zero. Option writers are obligated to honor the strike price should the put option be exercised.

Put option buyers have the right to sell the underlying asset for the strike price within a set time frame. For the right to do this, the buyer pays a premium. If the price falls under the strike price, the option will have a monetary value. This is referred to as intrinsic value. The buyer has the right to sell the option for a profit or exercise the option and sell the shares. Exercising the option allows the buyer to sell above the market value and earn a profit.

Put Option Strategies

Investors use put options to profit from a bearish outlook on a stock or other security. There are four strategies that investors can consider to minimize risk or maximize bearishness in the market: long put, short put, bear put spread, and protective put.

Long put

A long put is one of the most basic put options. The investor predicts the price of the stock or underlying commodity will decline within a certain time period, making this a bearish strategy. If the price drops before the expiration date of the contract, investors can sell their shares above market price and realize a profit.

Long options allow investors to invest in expensive stock without the capital to front the funds for it. Since the option is a contract that gives investors the option to sell shares, losses are capped at the premium price paid if the contract is not exercised.

Short put

A short put is an investment strategy that anticipates the price of the underlying stock to exceed or remain at the strike price, making this a bullish alternative to the long put. Short puts allow an investor to attempt to make money off the premium paid on the underlying investment. Short puts work by selling a put option. Sellers of put options are obligated to sell the underlying investment, which is riskier on individual stocks than indexes or other investments like commodities.

When you engage in a short put, you will want to sell when the market price is over the strike price, making it worthless to the buyer, and you will then profit from the premium.

Bear Put Spread

Long puts tend to be more bearish. A bear put spread is common when the investor is less bearish on a stock. Investors generate a bear put spread by shorting, or selling, a put option in which the current price has exceeded the strike price while simultaneously buying a higher-priced put option that currently has a strike price greater than the market price. The expiration date and amount of shares will be the same for each option.

Unlike short puts, losses are limited to the amount of the spread as the worst-case scenario is the stock close in excess of the strike price. In this situation, both contracts are worthless. Profits are limited, though. Bear put spread investors don’t have to worry about volatility since they simultaneously are long and short on the option. A bear put spread utilizes short put options to fund a long put option and mitigate the risk.

Protective Put

Protective put, or the married put, is a strategy that provides an investor a way to safeguard a long position on a regular stock. Protective puts use the options as indemnification for a regular stock position. To utilize this strategy, for every 100 shares of standard owned stock, you would purchase a put option at a specified strike price.

If a stock price declines below the strike price of the put option, investors will sustain losses on the stock, but they’ll be in the money for their put options, minimizing losses by how much the option is in the money.

Put options vary from high-risk to low-risk mitigation strategies depending on how the contracts are structured. Trading put options allows investors to control many shares of a stock without putting up the cash necessary to buy them. They can also be used to hedge or protect investments when the outlook turns bearish. Put options can be considered a form of insurance. Consider the premium for this insurance, as well as the strike price, when looking into this investment tool.