Investing > What is a Put Option?

What is a Put Option?

This guide will help investors grasp the basic yet important aspects of the put option contract.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Not sure what a put option is? Most people don’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. 

A put option is an investment contract that gives its holder the right, but not the obligation, to sell an underlying asset or security at a predetermined price before a particular date.

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. They help an investor apply strategies to balance out the dangers of holding stock, whether in the short or long term – and make a profit to boot. 

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.

Most traders are usually more aware of the put options more popular cousin, the call option. But put options are just as an important arsenal in an investor’s toolkit to protect their portfolio by helping to reduce losses while maximizing returns.

This article is dedicated to providing clarity to what put options do so investors can incorporate them effectively into their trading strategy.

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 timeframe 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”. 

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 investors 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).

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).

Note: With European options, you can only exercise the contract on the expiration date. With US option contracts on the other hand, a trader has the ability to exercise the option at any time before it expires, as long as it is in-the-money.

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.

Buying put options is also similar to purchasing insurance. Or, alternatively phrased: buying insurance is just like buying put options.

First, you pay a premium when you buy, say, car insurance. In return for the policy, the policyholder will receive a policy or protection. If an accident of damage occurs to the car, the insurance company is under obligation to make the policyholder whole; usually by repairing the vehicle.

After you’ve purchased the policy, there are several scenarios that can unfold afterwards. 

Car does not have damageCar has damage
Insurance buyerPays premium onlyPays premium; receives compensation for damage
Insurance sellerKeeps premiumKeeps premium

On the left-hand side where the damage doesn’t occur, the only thing that exchanges hands between policyholder and the insurance company is the premium. 

On the right-side, however, in addition to keeping the premium, the insurance company has to make the policyholder whole by compensating her for the damages incurred.

Now, let’s transpose this thinking to how put option contracts work.

Since the put options buyer paid a premium for the option contract, like the insurance policyholder, she has the right to be made whole according to the terms of the contract. In this instance, the right to sell her stock at the strike price.

If we take this similar analogy and do it for puts instead, this is how the table would look:

Stock or Asset Doesn’t Settle Below the Strike Price at ExpiryStock or Asset Settles Below the Strike Price at Expiration
Put buyerPays premium onlyPays premium plus has the right to sell at strike price
Put seller (writer)Keeps premiumKeeps premium plus obligated to buy stock at strike price

The parallel to our subject matter is that you purchase insurance on your stock by buying puts. Therefore, if you are long stock and you are apprehensive the stock value is going to fall, you protect it by buying puts.

The put buyer who bought the protection pays the premium, and if the stock settles below the strike price, you have the right to sell the stock at the strike price – like the face value of a homeowners policy.

The only difference is that the investor or trader doesn’t have to own what is being insured; they just have to own the right to buy or sell the underlying security at a certain price.

As opposed to call options which gives the buyer of the contract the right to buy, buying puts gives you the right to sell your stock or whatever asset is underlying it, if it expires in-the-money. Unlike call options, your gains aren’t unlimited but they are limited between the strike price and zero (since obviously, a stock can’t fall below zero). 

So, when you buy puts, the maximum you can make is the difference between the strike price and zero (of course, minus the premium that you spent).

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. 

Time decay simply means that the value of a put option falls as the time of expiration nears. On the other hand, the value of a put option  increases as the price of the asset on which they are based upon falls.

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 Call 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.

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.

This table below showcases the put option profits of ABC company in a snapshot with various strike prices:

Stock Price at ExpirationPut Option Profit
$120-$500
$110-$500
*$100-$500
$95$0
$90$500
$80$1,500
$70$2,500
$60$3,500
$50$4,500

Payoff Profile Graph

The payoff profile of a put contract would look like this in a graph.

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 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. 

The key differentiation in long and short options analysis is that with the former, the investor owns the stock, while in the latter, the investor owes the stock and is therefore obligated to pay it back.

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.

Still following this example, suppose an investor on the other hand sold 100 shares of Apple stock without yet owning the Apple stock.  In this instance, the investor is said to be short 100 shares. As a result, they would owe 100 Apple shares at settlement, and would have to purchase the shares in the market to deliver in order to fulfill her obligation. 

In practice, since the short investor hasn’t actually bought the shares, in order to deliver the goods, they usually borrow the shares from a brokerage firm in what is called a margin account. 

In a put contract, the financial incentives for the put option buyer and the put option seller (writer) are both different. The short investor (seller) hopes that the stock price will fall, thereby enabling them to purchase the stock at a lower price to pay back the dealer who loaned it to them. 

In a put option, the investor keeps the premium if the stock remains below the strike price at expiry. On the other hand, they are obligated to sell the security to the call option holder in the event that it rises above the strike (exercise) price.

In summary, the act of buying or holding either a put or call option is considered to be a long position. This is so because the investor owns the right (but not the obligation) to buy or sell to the writing investor at a certain price. 

In the opposite direction, the act of selling or writing a put or call option is regarded as a short position simply because the holder owes an obligation to sell the stock, and usually doesn’t already own the stock in the first place.

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.

Long Call: An investor who is the buyer of ABC August 50 call option has the right to purchase 100 shares of ABC stock at $50 a share until the August expiration date. The potential profit and loss graph will look like this:

Long Call
Potential ProfitPotential Loss
Profits are potentially unlimited as the underlying stock price continues to riseTotal loss is limited to the premium paid for the call option

We have mentioned that when put options are exercised, they provide a short position on the underlying asset. Consequently, that is why put options tend to be used for speculation on the downside price action of stock or simply for hedging purposes. 

However, put options aren’t the only derivatives that can hold a short position.

Short Call: Investors can sell an option contract that they don’t own themselves. These investors are known as the option writer and are then short the contract. Open writers are commonly called sellers. 

Option sellers have the right, but not the obligation, to sell 100 shares of the underlying stock at the strike (exercise) price if assigned an exercise notice at any time before the option expiration date. 

An investor who is a writer of ABC August 70 call option has the obligation to sell 100 shares of ABC stock at $70 per share if assigned at any time before the August expiration. The potential profit and loss graph will look like this:

Short Call
Potential ProfitPotential Loss
Limited to the premium the option seller received for the call’s initial saleLosses are potentially unlimited as the underlying stock price continues to rise

Long Put: Once a put option is purchased, the buyer is long on the contract. To sell 100 of her underlying shares, the put contract owner must notify her broker of her 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:

Long Put
Potential ProfitPotential Loss
Profits increase substantially as underlying stock assets decrease to zeroTotal loss is limited to the premium paid for the put option

Short Put: When an investor sells an option contract which they don’t already own, they become option writers to a short contract. The writer (seller) of a put option contract has 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.

Short Put
Potential ProfitPotential Loss
Total profit limited to the premium received for the put options initial saleLosses increase substantially as underlying stock assets decrease to zero

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 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.

FAQ Section

Needless to say, this isn’t an exhaustive list. Besides, we’ve already covered and explained most of the fundamental terms regarding put options, so consider this a bonus 🙂

What are derivatives?

Stocks, bonds, commodities, futures, and options are all securities that can be traded on a stock exchange. However, options below to a category of securities known as derivatives. 

As the name implies, they are linked to or derived from another security, from which they derive their underlying value like price. As a result, the option doesn’t have its own price, but rather, is dependent on the price changes of its security.

Underlying asset

In trading derivatives, the term refers to what the derivative is trading on. For instance, if you bought options on McDonald’s, then the underlying asset would be McDonald’s. 

What does it mean to go long 

The main difference 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. 

Put/call ratio: this ratio is obtained by dividing the total trading volume of put options by the total trading volume of call options. It is a supporting market segment indicator that helps investors gauge the market’s present attitude towards an index or security.

What is the difference between the strike price and exercise price

They are one and the same thing. They are the price at which the owner of the option contract can decide to buy or sell the underlying security within the expiration timeframe.

If the owner of the contract decides to use that right, then she is said to be “exercising” the option. 

Intrinsic value: the intrinsic value of a stock or option represents the difference between strike (exercise) price and the market value of the underlying asset.

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

Fees
Commissions

$0

$0

Account minimum

$0

$0

Minimum initial deposit

$5

TS Select: $2,000

TS GO: $0

General
Best for

New investors

Active options and penny stock trading

Highlight

Value-based investing

Powerful tools for professionals

Rating
Fees
Commissions

$0

$1, $2, or $3/month

Account minimum

$0

$5 required to start investing

Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0 to open account

General
Best for

Active options and penny stock trading

People who struggle to save

Highlight

Powerful tools for professionals

“Invest spare change” feature

Rating
Fees

Commissions

$0

$0

$1, $2, or $3/month

Account minimum

$0

$0

$5 required to start investing

Minimum initial deposit

$5

TS Select: $2,000

TS GO: $0

$0 to open account

General

Best for

New investors

Active options and penny stock trading

People who struggle to save

Highlight

Value-based investing

Powerful tools for professionals

“Invest spare change” feature

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Cookies & Privacy

TheTokenist.io uses cookies to provide you with a great experience and enables you to enjoy all the functionality of the site.