The put option definition is a contract that gives the owner the right to sell a set amount of an underlying security. This will need to be done at a specified price and within a set time frame. While a put option gives the owner the right to sell, they are in no way under any obligation to sell. The price that the put option carries is also referred to as a strike price. To better understand what a put option is, you will need to know:
- What assets can put options be used on?
- How do they work?
- What out of money and money put options are?
- Where you can trade them?
- Alternatives to exercising them.
- Examples of put options.
- Why owning them is appealing to investors?
- The difference between owning a put option and owning stock.
What Assets Can Put Options be Traded On?
Put options can be traded on a number of underlying assets, such as:
A put option is often the contrast to what is known as a call option, which gives the holder the right to buy at a specific price and time frame.
How Put Options Work?
A put option will gain value when the price of the stock depreciates relative to the strike price. It will lose its value if the underlying stock price increases. With a put option, you will be gaining the short position on the underlying asset, which you can use for speculating the downside price action. You can also choose a protective put, which will provide more protection as it will limit the losses of the underlying asset to a certain amount.
So if you can buy 100 shares of stock from someone who sells you the put option. This means you will have to decide what to do before the time expires in the contract. In the event that the price of the stock on the market drops below the strike price that was specified in the contract, then it is likely in your best interest to sell the option at the higher strike price. If the market price of the stock continues to be higher than the strike price, you will want to let the option expire. You can then sell the stock on the open market at a higher price.
Put simply, the value of the put option will decrease due to time decay as it approaches its expiration date. This is because the probability of the stock falling below the strike price lessens. If a put option loses its time value, then it will be left with its intrinsic value, which will be the difference between what the strike price is and what the underlying price of the stock is.
Out of Money and Money Put Options
Out of the money and at the money put options will have no intrinsic value, which gives no benefit to exercise the option. There is still the option to short sell the stock at the higher current market price instead of exercising the out in a money put option that would be at a less than desirable strike price.
Where Can You Trade Put Options?
Put options, as well as other types of options, will be traded through brokerages. There is some brokerage that may specialize in these more and prove to be a better fit to handle your trading. If you are looking to begin trading in options, it is always a good idea to find the right broker to fit with your investment needs.
Other Alternative to Exercising a Put Option
The put seller, also sometimes referred to as the writer of the option, does not have to hold the option until the expiration date. The premium of the option will move along with the underlying stock prices to reflect the recent price movements, sometimes making it better to choose another course instead of exercising the put option. The buyer of the put option has the right to seal that option at any time, and they may do so to either recoup part of the premium or cut their overall losses.
The put seller has this right as well. For example, if the underlying price was to exceed the strike price, then they may let the put option expire so that they can keep the whole premium. In cases where the underlying price drops below the strike price or is even approaching it, they may choose to buy the option back to reduce the risk of suffering a big loss. In this case, the profit or loss will be the difference between the collected and the paid premium.
Examples of Put Options
An example of a put option transaction would be an investor owning one put option where the current trading price is $377 and a strike price at $360, with the option expiring in just over a month. They bought the option at a premium of $0.80, of $80 per 100 shares.
In this case, the investor can sell the 100 shares they have purchased at the strike price of $360 until the option expires. In the event that price falls to $350, then the investor can exercise the option and purchase another 100 shares of the stock that they can sell back to the seller for the original strike price of $360. This would make the investor a profit of $920 on the option, which is what they make ($1,000), minus the premium they paid ($80.) If they were to suffer the maximum loss on the trade, it would be their premium investment of $80.
A short put option creates the obligation of the investor to either take delivery or purchase the agreed on shares of stock. Say an investor is looking at ABC, which is trading at $314 and does not believe that it will fall lower than $300 in a short time frame. This investor could choose to make money off of a premium, by writing an option for a premium of $80 per 100 shares with a strike price of $300.
As long as the stock stays above the strike price, then the investor can guarantee to profit off of the premium, as the option would expire worthlessly. This can come with a risk, though. If the stock were to move below the strike price, then they could end up having to pay for 100 shares at a higher rate. So if the stock were to fall to zero, that would mean the investor in the above scenario would be on the hook for $30,000.
Why Put Options Are Appealing to Investors?
Many investors find put options attractive because they allow investors to benefits when stock prices begin to fall. When you own the stock, having a put option can help protect you from losses if the stock were to drop below the strike price. You also can play it safe and exercise the option at any time to get the fixed amount indicated on the contract.
Buying put options can also be more advantageous than selling a stock, as it allows you also to benefit when the stock price increases. When you don’t own the stock but own an option, you can profit off of its decline.
Put Options vs. Owning Stock
With any type of investor, you are in it to make a profit, and put options can help get you there. While selling stock that is on an upward motion can allow you to make significantly higher profits upfront, you can also suffer major losses when the stock begins to drop. Put options may give you less profit in some instances, but allow you more protection, allowing you to gain more consistent profits than holding stock alone.
In many cases, a put option can serve a defensive measure if you find out that your predictions on the stock are not justified. Selling a stock early means that you lose out on the profit from the gains that could have been made, but when you buy a put option, you can never lose more than the initial premium that you paid for the option.
While many investors may buy options of the stock they own, owning just a put option without shares of the underlying stock, allows you top benefit, when you feel that a stock may struggle or have a downward turn. If this were to occur when you owned the stock and the put options, you gain from the option would likely be washed by the losses you incurred with the stock. If you only had the put option, you would be able to reap the total benefits that come with it. For example, if you bought a put option on a stock that has fallen from $90 to $70, you would be able to collect all profits by selling the option before it expires without taking a loss on the drop in the stock price.
Put options are a beneficial tool that is used by many investors to help mitigate some of the risks in their portfolio or the take advantage of a stock that you think will begin to fail. By buying put options, you will have greater flexibility and may garner higher returns than owning stock alone. Want to learn more about buying and selling out options? Download our free e-book, or sign up for our webinar.