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The Basics of Put Options

When trading options, you can choose between two types of options contracts: put options and call options. Each type of option gives you different rights that you can exercise, but no obligation to do so. Learn more about what put options are and how to use them effectively.

Key Takeaways

  • A put option gives you the right, but not the obligation, to sell an underlying security at a set price on or before a predetermined date.
  • With a U.S.-style option, you can sell anytime on or before the expiration date. With a European-style option, you can only sell on the expiration date.
  • You must trade all kinds of options through a brokerage firm, unless you trade through the over-the-counter (OTC) market.
  • A put option contract represents 100 shares of the underlying stock. Find the cost of your option by multiplying the share price of an underlying stock by 100.
  • Some investors love put options because they give them more investment choices, such as earning an income, limiting their risk, and getting a better buying price.

What Is a Put Option?

A put option is a contract that gives you the right to sell an underlying security at a set price on or before a predetermined date. This set price you can sell at is called the strike price. A call option, on the other hand, gives you the right to buy an underlying security within these same conditions. With both put and call options, you have the right to buy or sell, without any obligation to do so. You can trade a put option on different underlying assets, like stocks, commodities, futures, indexes, and currencies.

How Do Put Options Work?

The way put options work depends on where you trade. The U.S. options give you the right to sell at your set price any time on or before the expiration date. This means the buyer of a put option has the right to sell right away or to wait until the last minute. With a European-style option, you can only sell on the expiration date, not before it. The location you are trading can greatly impact your selling strategy.

Options contracts are set with a weekly, monthly, or quarterly expiration date. The term length you look for depends on if you want a short-term or long-term investment.

When you’re a put buyer, you get your right to sell by paying a premium. If the price of your underlying asset moves below the strike price, you can make a profit off of your option. When an option is worth money, it is said to have intrinsic value. In this scenario, most put buyers choose to sell their shares.

The seller of a put, also called a writer, receives the premium from the buyer. By writing put options, you can earn an income. Keep in mind, your income from this only comes from the premium. When you’re a put buyer, you can make more profit until the stock reaches zero.

Where Can You Trade Put Options?

Image via Unsplash by Adam Nowakowski

You need to use a brokerage firm to trade both put and call options. Brokers who specialize in options trading have different resources you can use to make smart investments. They may offer you one-on-one support and advice to help you make wise additions to your portfolio.

When you want to start trading options, your broker will assess what level of options trading you qualify for. They do this by having you fill out a form and seeing which criteria you fit into. If you’d rather trade without a brokerage firm, you could trade through over-the-counter (OTC) markets, where trades happen on a party-to-party basis.

How Do You Calculate the Cost of a Put Option?

Both put and call option contracts represent 100 shares of the underlying stock. You can find the price of your contract by multiplying the share price of an underlying stock by 100. For example, if each share costs $5, your put option would cost $500.

Here are a few important terms to know when looking at the underlying price of a put option:

  • In the money: When the underlying asset price is lower than the put strike price.
  • Out of the money: When the underlying asset price is higher than the put strike price.
  • At the money: When the underlying asset price and put strike price are the same.

Buying a Put Option

Investors typically buy a put option when they anticipate the stock to decline in price. If the price of the stock were to decline below the strike price prior to the expiration date, the option is in the money. You then have the choice to sell the option at its strike price, which would mean you are selling it for more than you purchased it for and you make a profit. You could also decide to sell your put option prior to the expiration date to get the most value. This choice can be beneficial if you don’t want to sell any underlying stock.

Keep in mind, if you purchase a put option and the stock remains equal to or above the strike price, you can lose your entire investment. This is when the put is considered out of the money.

Selling a Put Option

Unlike a put buyer, a put seller must purchase the underlying stock at the strike price until the expiration date. To do this, you need enough margin capacity or money in the account to purchase the stock from the put buyer. Remember that put buyers usually wait to exercise their right until the stock price is under the strike price, or the put option is in the money. Many put sellers anticipate the price of an underlying stock to increase or stay the same.

The Difference Between Puts and Short Selling

When you think a stock’s price will decline, you may feel inclined to buy a put option. Another strategy is short selling. This means that your broker borrows the stock for you, you sell it, and then you purchase it again if the price declines. Your profit is whatever the difference is between your sell and buy prices. The reason put buyers prefer puts to short selling is because they can be much more lucrative if you hit the market right.

Other Put Trading Strategies

When you’re bearish, you think that the market is going to experience a downward trend. That’s why put investors try to capitalize on a bearish market with these options trading strategies:

  • Long put: When you purchase a put option with the prediction that an underlying asset will decline. If it does fall, this can increase the value of the long put.
  • Bear put spread: When you buy a put with an underlying asset that you think will decline. You can offset the cost of this purchase by writing a different put with the same end date and a lower strike price.
  • Protective put: Also called a married put, this is a strategy to protect your long position on a regular stock. Buying a put option for every 100 shares of a normal stock can act as insurance for your position.

The Benefits of Put Options

Investors enjoy trading put options because they give you the following investment choices:

  • Earn income. When you sell your options, you can build a steady income from your premium. When using this method in moderation, you can see returns on a rising market.
  • Limit your risks. Adding a put option contract to your portfolio can help you lower your risk. Limiting your potential losses gives you the chance to invest in high-risk assets.
  • Get better buy prices. If you have your eye on a stock but it’s too expensive, one strategy is to sell puts on this stock to get a better price. When you see this price go lower than the strike price of the put, you can purchase the stock and use the premium as a discount on your purchase. When the stock’s price stays higher than the strike price, you can keep your premium and try this method again.

Getting started on options trading may seem a bit complicated at first. With some proper guidance and training, you can begin to make smart investments and enhance your portfolio.