Understanding Put Options: Basics, Benefits, and Strategies
Put option contracts are versatile financial instruments used by traders for various strategies, including hedging against potential losses and speculating on price declines. In this article, we will explore what put options are, how they work, the processes and reasons for buying and selling put options, the differences between these actions, and the associated risks.
Key Points
Put option contracts allow traders to trade a stock with much less capital requirement than outright shorting the shares.
Buying put options (or going short) limits the loss potential on a trade to just the premium paid to own the contract.
Selling put options on a stock that a trader wants to own at a lower price allows the trader to profit from a neutral to bullish market by collecting the premium a buyer of a put option would pay while waiting for the stock to drop in price to their strike.
Risks of buying put options include premium loss and time decay.
Risks of selling put options include no limit on loss potential and being obligated to buy shares of a stock they sold the put on.
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What are Put Options?
A put option is a financial contract that gives the buyer the right, but not the obligation, to sell a specific quantity of an underlying asset (such as a stock) at a predetermined price (the strike price) within a specified period. The seller of the put option is obligated to buy the underlying asset at the strike price if the buyer exercises the option.
How Do Put Options Work?
When a trader buys a put option, they pay a premium to the seller for the right to sell the underlying asset at the strike price. If the market price of the asset falls below the strike price before the option expires, the buyer can exercise the option to sell the asset at the higher strike price, potentially buying it back at the lower market price for a profit. If the market price does not fall below the strike price, the option expires worthless, and the buyer loses only the premium paid.
For instance:
A trader believes Stock XYZ will move lower from the current price of $250.
They purchase a put option for Stock XYZ at a strike price of $250 with a one week expiry on 6/14. This put option contract costed them $175.
On 6/12, Stock XYZ close at a price of $240. The trader executes the contract and purchases 100 shares at the strike price of $250 and immediately sells them at the current market price of $240. The net profit from this trade is ($250 - $240) x 100 shares - $175 premium = $825.
However, most traders will not exercise the put options as described above. As the price of the underlying stock moves lower, the value of your put option will increase. You can then sell your put option contract and your profit will be the difference between the premium you paid and the premium of the put option contract at the time of the sale.
Using the same instance as above:
A trader believes Stock XYZ will move lower from the current price of $250.
They purchase a put option for Stock XYZ at a strike price of $250 with a one week expiry on 6/21. This put option contract costed them $175.
On 6/12, Stock XYZ close at a price of $240. The option contract they are holding is now worth $375 and they choose to sell it. The net profit from this trade is $375 - $100 = $200.
Utilizing put options allows a trader to utilize less capital to achieve more significant returns on trades they take. If they trader above only had $300 to trade and they chose to short shares of Stock XYZ instead of a put option contract, they would have only been able to trade one share and receive a net profit of $410when they sell it on 6/12.
Buying Put Options
How to Buy Put Options:
Select an Underlying Asset: Choose a stock or other asset you believe will decrease in value.
Choose an Expiration Date: Determine how long you want the option to be valid.
Pick a Strike Price: Select the price at which you want the right to purchase the asset.
Pay the Premium: Buy the put option by paying the premium to the seller.
Reasons to Buy Put Options:
Speculation: Traders buy put options to profit from an anticipated decline in the underlying asset’s price.
Hedging: Investors use put options to protect their portfolios from potential losses in the value of the assets they own.
Leverage: Put options allow traders to control a larger amount of the asset with a smaller investment.
Limited Risk: The maximum loss is limited to the premium paid, unlike short selling the asset outright.
As the price of the stock increases, the value of the options contract you hold will increase with it. There is no limit to how much the option will increase in value. However as the stock price decreases, the value of the option will decrease with it, but only to a maximum of the premium paid to own the option.
Selling Put Options
How to Sell Put Options:
Have the Required Capital to Buy Shares: Selling a put option requires you to have the capital to purchase 100 shares for each contract you are selling (also called a Cash-Secured Put).
Naked Put: Selling a put option without having the capital required to buy the shares (can only be done with Options level 4 approval).
Collect the Premium: Sell the put option and receive the premium from the buyer.
Reasons to Sell Put Options:
Generate Income: Sellers earn premiums, providing income from the sale of put options.
Acquire Assets at a Discount: If the option is exercised, the seller buys the asset at the strike price, potentially lower than the market price.
Speculation: Traders may sell puts if they expect the asset price to remain stable or increase.
The intention behind selling a put option is very different. This trade is typically called a Cash-Secured Put strategy and you’re only able to do this if you have the capital to purchase 100 shares for every put option contract you sell. With this trade, you want the price of the stock to stay above the strike price of the put option you sell. If it does, then your max profit is the premium you collected from selling the put option. However if the price closes below your strike price on the expiration date, then you must buy 100 shares of the stock (per contract sold) at the strike price selected.
Risks of Buying and Selling Put Options
These are the risks associated with buying put options:
Premium Loss: If the asset price does not fall below the strike price, the option expires worthless, and the premium is lost.
Time Decay: The value of the option decreases as the expiration date approaches. So if price is not able to move low enough before expiration, the trader can still lose money due time decay.
These are the risks associated with selling call options:
No Limit on Loss Potential: If the asset price falls significantly, the seller must buy the asset at the strike price, potentially incurring a substantial loss.
Obligation to Buy: The seller is obligated to buy the asset if the option is exercised.
Simple Examples
Example #1 - Buying a Call Option
Scenario: You believe stock XYZ, currently trading at $100, will decrease in value.
Action: You buy a put option with a strike price of $95 and an expiration date one month away, paying a $2 premium.
Outcome: If XYZ falls to $90, you exercise the option, sell at $95, and buy at $90, making a profit of $3 per share ($95 - $90 - $2 premium). If XYZ stays above $95, the option expires worthless, and you lose the $2 premium.
Example #2 - Selling a Call Option
Scenario: You own stock XYZ, currently trading at $100, and believe it will not rise significantly.
Action: You sell a call option with a strike price of $105 and an expiration date one month away, receiving a $2 premium.
Outcome: If XYZ stays below $105, the option expires worthless, and you keep the $2 premium. If XYZ rises above $105, you sell the stock at $105, potentially missing out on higher gains but still earning the premium.
Conclusion
Put option contracts offer traders and investors a versatile tool for managing risk, speculating on price movements, and generating income. Understanding how to buy and sell put options, the differences between these actions, and the associated risks is crucial for making informed trading decisions. While put options can provide significant opportunities, they also carry risks that must be carefully managed.
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Disclaimer: The information provided in this article is for educational purposes only and should not be construed as financial advice. Always conduct your own research and consult with a professional financial advisor before making any investment decisions.
