What is a Put Option?

Not sure what a put option is?

Most people aren’t, as they’re one of the more complicated aspects of investing. If you’re looking for an easy, yet in-depth guide to learn about put options, you’ve come to the right place. 👍

Put options can be traded on a range of financial instruments such as stocks, commodities, currencies, bonds, futures, and indexes. 

Put options are quite versatile instruments and they can help investors limit their losses. And even though some experts are as bullish as ever, the crashes and other black swans of the past tell us we always need to be careful.

The volatility of the stock market is nothing new to seasoned investors but a put option is a financial instrument they use to put (no pun intended) their minds at ease and protect their investments. Think of it as insurance against falling stock prices.

In this article, we will explain exactly what put options are, how they work, how they can be used in a proper trading strategy, and how they mesh with their counterpart—call options. Let’s jump straight in.

What is a Put Option, Exactly? 👇

If we’re talking about the basics of a put option, it doesn’t get more fundamental than the root of its genesis—the option contract.

But before we get ahead of ourselves, let’s define what a put option entails. A put option is a type of options contract that grants the owner the right, but not the obligation, to short or sell an underlying security asset at a predetermined price before a certain time frame expires.

A put option is derived from option contracts. An option is an agreement between two parties, often a buyer and seller, that enables the purchaser of the option to facilitate a potential transaction involving an asset at a predetermined price and date. 

An option contract gives the owner the right to buy or sell the asset at the expressed or strike price. In case the buyer chooses to capitalize on that right, they are deemed to be “exercising” the option contract.

Distilled to its essential form, options ask this basic question: what will the value of a particular stock be worth at some future point in time? It isn’t exactly rocket science as there are only two possible responses—the stock is either going to be worth more or less than its current price.

In the case of a put option, by purchasing one, the owner of the contract is essentially betting that the value of the stock is going to be worth “less”. 

All in all, put options are a tool for betting against a stock. Alternatively, if you’re betting on a stock to go up, and it unexpectedly starts going down, you can use a put option to limit your losses.

Put Option Characteristics 📋

Options share a common denominator of features that are important to grasp and we’ll be discussing most of these in relation to put options down the line.  As a reader, you’ll be well served to grasp these foundational concepts as we’ll delve into some of these common themes while exploring put options:

• Option contracts devalue with time; so time works against you with put options. Therefore, you have to make or earn above that time value for the trade to be profitable. This is known as options’ time decay; meaning that the value of an option decays with each day that passes. 
• When buying options—put options inclusive, the premium that you spend on purchasing the option is the maximum amount you can lose. Limiting an investor’s risk to the premium spent is a huge benefit. Thus, an investor can sleep easily at night knowing that the floor is set on their losses while their ceiling is potentially unlimited. Hence, buy options are popular since people want to understand their risk exposure from the onset.
• As a corollary to the above point, the gains on a trade are (potentially) unlimited for call options. With put options however, profits are limited to zero stock price (we’ll see how this calculus is feasible later on). 
• An investor has the right to buy or sell the underlying security if the option contract expires in-the-money (ITM).
• Options are easier and quicker to trade than stocks, but only if the market you are in has a huge number of options writers ready to sell you their contracts. This is why options traders only use the most popular options trading brokers to maximize their profits.

When someone purchases a put option, they have acquired the right, but not the obligation, to sell 100 shares of an underlying security at a particular price (known as the strike price) anytime before the option expires (known as the expiration date).

At the basic level, an approximate real-life analogy that equates to the way a put option works that most people will be familiar with is buying insurance.

First, you pay a premium when you buy, say, car insurance. If nothing happens to the car, you just lost the money you gave on the premium. However, if the car gets totaled, you get a sum of money, much larger than the premium you paid.

Put options are exactly the same—but you’re buying insurance on someone else’s car. When a stock you got a put option for goes down in price, you get paid. It’s that simple.

Weighing the Risks of Put Options ⚖️

The catch is, that all options have an expiry date—if you can’t cash-in by that exact date, the contract becomes worthless, and you can use it to wipe the dirt off your windshield (and maybe not even that because contracts are digital nowadays).

Another catch is that the person selling the options contract is hoping for the opposite of what you’re cheering for. If they sell you a put option, they’re hoping the underlying stock will go up and that your contract will become worthless—that way, they don’t have to pay you anything but can keep the premium you had given them.

Since options writers don’t want to lose money, they will only sell you options with a high likely hood of success for you for a very high price. If you want profitable options with a high success rate, you have to do excellent stock research and be smarter than your competition.

All things considered, using put options is slightly more complicated than buying a stock outright. That is why it is recommended for beginners to jump straight into options trading before becoming experienced researchers and budget managers.

How a Put Option Works 🧐

The value of put options are affected by two elements: by time decay and the price of the underlying asset. 

Based on this, the trader decides to buy ABC June 50 put option. In layman’s terms, this means the trader has the purchased right to buy 100 shares of ABC stock at $50 per share up until the April expiration date. The caveat, however, in all option contracts still remains: the trader maintains the right to purchase the stock at this price before the expiry; however, they aren’t obliged to do so.

At the expiration date of the put contract, if the stock of ABC shares happens to be trading lower than the strike price of $50, then the put contract is said to be in-the-money (ITM) because it is, well, worth money.

In this scenario, to calculate the profit the investor made from the put contract, you first subtract the stock price from the strike price, then multiply the result by 100 (each contract is worth 100 shares). However, if the price of ABC shares are higher than the strike price at the end of expiry, the put contract is worthless.

How Do You Profit From a Put Option? 💸

When an investor purchases a put option, they are said to have gone “long” on the put contract (we’ll look into the meaning of long as it pertains to contracts later on). But suffice it to say at this point that it simply means that they have become the owner of the option contract. 

Generally, people choose to invest in securities like stock because they anticipate the price will go up. However, there may be times when an investor, for any combination of reasons, anticipates that the price of the stock will instead go down. If the trader already owns shares of the stock, they might even decide to offload them to limit their losses. 

But what if the investor could actually make money from a stock that she thinks is destined to go down? In this scenario, a put option would be the ideal financial instrument to unlock the financial potential through shorting the stock. 

For instance, assume there is a (fictitious) company named ABC trading on the stock market. A trader might have reason to believe that the stock price of ABC will likely plummet in the coming weeks or months. 

This idea might be nothing more than a hunch. But for savvy investors, it is usually an educated guess based on some unfavorable news events that might impact the movement of the stock, such as negative corporate earnings or inability to pay dividends. 

As we have indicated, put options are an ideal tool to make money for an investor when the stock price of a company falls. To do so, the investor has to first buy a put option. At the end of the expiration, the profitability of the option contract depends on whether it is in-the-money (ITM), or out-of-the-money (OTM).

Although they have bought the put, the investor doesn’t have to own what is being insured. In the event that the stocks underlying put option declines below the strike price, it is said to be “in the money.” In this scenario, there are two pathways to profitability for the investor.

If the investor owns the stock, they can decide to exercise the contract; this means putting the stock or security to the put seller. This way, the investor is essentially selling the stock at above market price, and thereby earning a profit.

Investors Can Sell the Put Before it Expires 💳

Alternatively, especially if they don’t own the shares, the investor can decide to sell the put before it expires. That way, they can capture its value without having to sell any underlying stock. 

This is theoretically how it works to make a profit from a put contract. However, you also have to consider the breakeven point, which is the point below which the option starts to earn a profit.

Going back to our fictitious ABC stock, let’s assume it is currently trading at $100 per share. In the market, puts for ABC stock are available with a strike price of $100 at $5 per contract, expiring in six months. 

The total cost of purchasing this put will be $500, since each option contract is worth 100 shares (1 put x $5 x 100). This is the equivalent of the premium paid for the contract.

However, if the stock price stays above or the same as the strike price, the option contract is said to be “out of the money,” with the unfortunate aftermath of the investor losing the entire investment. 

To obtain the put option’s profit, first calculate the gross profit by subtracting the stock price from the strike price. The final profit can then be obtained by subtracting the premium paid from the gross profit.

For example, suppose the strike price of ABC stock is $90 at expiration. The gross profit will be: ($100 – $90) x 100  = $1,000. The actual profit is obtained by subtracting the premium ($1,000 – $500) paid for the contract, which leaves us with $500 net.

The Difference Between Going Long and Short ↔️

In financial matters, the terms long and short can refer to several things. In investment, the term “long” generally means the duration of time an investment is held. In capital markets, the more conventional trading practice is to go long on a stock or a bond. 

However, it has an entirely different meaning when used with option and futures contracts. Instead of a reference to the length of duration, with regard to options, long and short positions refer to the stock an investor owns, and the stock an investor needs to own respectively.

Therefore, when an investor has bought a share of stocks, they are said to have a long position because they own those stocks. Conversely, a short position indicates that the investor owes those stocks to another party, and doesn’t actually own them. 

When an investor buys 100 shares of Apple stock, since they have been paid in full, the investor owns those shares outrightly and is said to be long 100 shares. A short position means that the investor owes this stock to another person or entity though they haven’t actually bought them yet.

How Can You “Owe” Stocks and Still Profit?

An investor can sign a contract that basically says “you give me your 100 shares of Apple, and I am obliged to give them back to you + pay a premium at a later date.” This can be done through put options, and it is how you can get to “owe” someone stocks.

In this instance, you would be “short” 100 shares of AAPL. But what’s the point of going short in the first place then?

If the stock you bought is worth $100 today, you can sell the 100 shares you borrowed for a total of $10,000—but that means you will have to buy back the shares later and give them back to the lender. Here is the trick.

If the stock drops from $100 to $80 in the meantime, before the expiration date of your contract comes around, you’ll be able to buy the stocks back at $8,000. That will leave you at a profit of $2,000.

All in all, going long makes sense if you think your stock will go up in price, and going short is best if you think a stock will lose value soon. These two positions are opposite and both carry risks—but be especially careful when shorting as a jump in the price of the stock you’re shorting can potentially cost you your entire portfolio.

Put Options, Hedging, and Speculations ⬇️

We have already written about how speculations work generally. Put options provide immense benefits to those willing to hedge their bets.

Put options are a short position on its underlying asset, which enables puts to be used to speculate or hedge on the downside price action of the security. A protective put is one of the risk-management strategies investors often utilize with put options in this role. 

The protective put is a hedging strategy whereby an investor is long on shares (she owns or buys the shares of the stock) but simultaneously purchases enough put options to cover those shares. 

As we have indicated, when an investor is long (or has a long position) on a security, it essentially means that the investor is purchasing the stock, currency, and commodity they intend to keep in their portfolio with the expectation that its price will rise in value. 

While holding a long position amounts to a bullish view of the underlying stock, the investor is still exposed to risk in the event that the stock declines below the purchase price. To prevent this outcome, the investor can purchase a put option so that any losses incurred on the stock are capped and limited.

This is because a protective put sets a protective floor price below or beyond which the investor wouldn’t lose any more money even if the underlying stocks price continues to experience a free fall.

What Are the Differences Between a Put Option and a Call Option 📜

The main differences between these two is what happens to each with the movement of the stock. As the underlying stock decreases, a put option becomes more valuable. On the other hand, as the underlying stock increases, the put option increasingly loses its value. 

A put option is the opposite of a call option, which gives the holder the opportunity, but not the obligation, to buy an underlying security such as a stock at a particular price, on a predetermined date.

A trader hoping to benefit and take advantage of a rise in price movement on an asset will go “long” on a call option. The call option will allow the holder to buy the underlying asset at a particular price.

In summary, you use call options to buy stocks that are about to grow in price, whereas you use put options to sell stocks that are strong now but will lose value in the future. Both can also be used together in order to hedge a trade that seems to be sliding out of control.

Long Put and Short Put ↔️

There two main ways put options can be used, either long or short. What you use them for depends on what you think will happen to the stocks—here is how this works.

Long Put 🚀

Once a put option is purchased, the buyer is long on the contract. To sell 100 of their underlying shares, the put contract owner must notify her broker of their intent to exercise the put contract. 

Therefore, the buyer of one ABC July 75 put option has the right to sell 100 shares of ABC stock at $75 per share up until the July expiry. The potential profit and loss graph will look like this:

Ideally, you want the price of ABC stock to drop to infernal depths if possible by expiry date. That way, you will be able to buy the stock super-cheap and sell it for the price in your options contract.

However, if the price of the stock continues going up as the expiry date nears, you’re in for a loss—but you can mitigate that loss. If a stock you own put options on starts going up, buy a call option—you will lose money on the put but earn most of it back on the call, or vice-versa.

Short Put 👇

You can write a put option and sell it to willing traders. In that case, you (the writer and seller) have the obligation to buy 100 shares of the underlying stock at the stated exercise (strike) price if they are assigned or given an exercise notice before the option expires.

Essentially, you sell the options, take the money, and hope the underlying security doesn’t go up in price because you’ll have to buy it at a high price. Your max profit here is realized if the underlying stock reaches 0, but your maximum losses are potentially unlimited.

For example, if you write and sell a put option that means you have to buy 100 shares of ABC in a month, you don’t want it to go up. If ABC unexpectedly went from $15 to $400 like GameStop, you would probably go bankrupt come expiry date.

To be safe, you can also buy a call option just in case the stock jumps. However, if you find yourself in that unforgiving situation, your best way of getting out is either shorting the stock at its new high price or buying a put option yourself.

Shorting selling stocks is highly risky because the upside is limited and the downside is potentially infinite. Therefore, only short stocks you’re certain about—a bad prediction in this field can cost an arm and a leg.

Comparing and Contrasting Put and Call Options Strategies 🔍

The popularity of the put and call options lies in their versatility, especially for their use of risk/reward option strategies.

Buying a call – this is the most common and basic strategy traders use when employing an option contract. Its attraction is its comparative low-risk strategy: maximum loss is capped at the premium paid by the call buyer; while maximum profit is limitless.

However, trades face low odds of being profitable.

Writing a call – in contrast to buying a call, writing a call boils down to two forms: covered and naked calls. Both are beyond the scope of this article, but they are the province of risk-tolerant, usually advanced option traders.

Buying a put – this allows the put buyer to generate capital gains (profits resulting from the sale of a capital asset) while simultaneously limiting risk-taking. If the trade works out, this strategy presents an ideal opportunity with relatively low-risk, but potentially high-rewards.

An investor who desires to take advantage of a decline in ABC stock could profit from the stock’s decrease in value by buying a put contract while limiting their downside to $500. 

Writing a put – the main advantage of put writing is that it has a higher probability of earning a profit. The greatest risk with put writing, however, is the danger that the writer may pay too much for a tanking stock. In addition, it also provides a more unfavorable risk/reward profile for the writer than put or call buying because its maximum reward is only the premium that was paid, while its maximum loss is much higher.

Conclusion

A put option gives the holder the right, but not the obligation, to sell an underlying security such as a stock at a particular price, on a predetermined date. The value of a put option also decreases as the expiration date approaches.

Put options are often leveraged as risk-management tools, or speculative devices.

A put option is typically a bearish view of the market. This negative sentiment is why traders want to protect their stock, especially their long stock positions. But apart from protecting stock holdings from a market place decline, put options provide other benefits too.

Put options allow an investor to prepare to buy an asset at a lower price, then take advantage of the rise in a stock price (buying the stock outright), and increase her income against her portfolio of current stock holdings.

Trade Put Options with a Broker