Put Options: An Introduction and How to Trade Them
Put options are financial contracts that give the holder the right – but not the obligation – to sell an underlying stock or asset at a specified price (the strike price) within a certain time period. Generally, when an investor buys a put option, they think that the price of the underlying stock will go down. As the price of the underlying asset decreases, the option holder will make money.
You can buy put options to speculate on stocks going down in value and magnify your returns. You can also sell the options if you’re bullish and think the price of the underlying stock will increase.
Investors can make a lot of money using options, but they also pose significant risk. In this article, we will go into detail on put options and how to use them.
What Are Put Options?
Purchasing put options on stocks is different from purchasing stocks outright. For example, let’s say a stock – we’ll call it XYZ Stock – is currently trading at $100. If you think the price of XYZ Stock will decrease there are a few investment strategies you can use. For example, you could short sell 100 shares of the stock directly.
But another strategy is to buy a put option on the stock. The price you pay for the put option is known as a premium. Often, the price of a stock option is low compared with the current price of the underlying stock. Therefore, it can have a much lower initial cash outlay than buying a full share of stock.
Let’s say you buy a put option on 100 shares of XYZ Stock for $500 that expires on December 20. By that date, you can sell the shares at this specified price or you can let the option expire. The lower the price of XYZ Stock (below the strike price) when you execute the option, the more money you will make on the trade.
Features of Put Options
There are different features of put options that you should be familiar with.
- The Premium – The current purchase price of a put option
- Strike Price – The specified purchase price of the underlying stock where the investor has the right to sell
- Expiration Date (Strike Date) – The date until which the option holder has the right to sell the underlying stock
- Time to Maturity – The time remaining until the expiration date
Factors like the strike price, the expiration date and the current price of the underlying stock help to determine the current premium of a put. For example, as the share price of XYZ Stock decreases, the premium for the put option will increase, and the opposite is also true.
An Example of How It Works
Sticking with our XYZ Stock example, let’s say that the current price of the stock is $100. You purchase a put option to sell 100 shares with a strike price of $100 and an expiration date of December 20. The premium you pay for the option is $500.
On December 20, XYZ stock is trading at $90. Because the put you hold is in the money – meaning the current share price is below your put strike price – you can sell the put for a gain or exercise it. In order to do so, you first purchase the 100 shares on the open exchange at the current price of $90 per share, for a total of $9,000. Then, you sell all your shares at the market price of $100 for a total of $10,000. The spread between what you earned and what you spent is $10,000 – $9,000 = $1,000.
To calculate your total return on the put, you need to factor in the premium you paid to buy it. So your total return on the trade would be ($10,000 – $9,000 – $500) / $500 = $500 / $500 = 100% return. Not too shabby!
Another feature of put options is that you can also sell them. When selling put options, you immediately earn the premium price you are paid for the option. Continuing with our example, let’s say you were the seller in the transaction and sold an option on 100 shares of XYZ Stock for a premium of $500.
The $500 premium is now your income to keep. However, the contract obligates you to buy shares of XYZ from the put holder if they exercise the option by the expiration date.
If the price of XYZ is above the strike price, the put becomes worthless – it is considered out of the money – and you get to keep the entire $500 as your income on the trade.
However, let’s say that the stock is trading at $90 on the expiration date, and the holder exercises the option. Now you are obligated to buy their 100 shares of XYZ Stock for $100 each. The cost to you: $100 x 100 shares = $10,000. You can continue holding the shares or immediately sell them on the open market for $90 each ($90 x 100 = $9,000). One way to calculate your total return on the trade is the $9,000 sale price minus the $10,000 purchase price plus the premium you earned on the initial sale. So your return would be ($9,000 – $10,000 + $500) = -$500.
The $500 you initially collect isn’t money you have to contribute to make the trade, though. Brokers require margin – a percentage of the trade’s value – to be kept in your account to initiate and maintain this type of trade. So comparing the gain with the margin requirement can also be a useful return calculation.
When selling puts, the lower the underlying share price below the strike price on the expiration date, the more money you lose on the trade. This makes selling puts a risky strategy, because the price of the stock can go all the way to zero and you would still need to purchase the shares at the strike price from the holder.
Concluding Thoughts on Put Options
Put options can be a useful tool for making large returns in a relatively short amount of time. Compared with short selling an individual stock at full price, buying a put on a stock can quickly magnify your gains in a major way, and even cut down on some of the risk inherent to short selling.
Now that you have a more thorough understanding of put options, you can use them to make money by buying them, selling them or using them in combination with other options and assets to make profits. And keep an eye out for the next article in this series on options trading, where we discuss selling covered calls. There are lots of investment strategies to consider today…
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.