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, and that the option holder will make money as the price of the underlying stock decreases.
You can buy put options to speculate on stocks going down in value and to magnify your returns, or you can 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 is going to decrease over time, you might short sell 100 shares of the stock directly.
But another strategy is to buy a put option on the stock. The price you pay to buy a 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 purchase a put option on 100 shares of XYZ Stock for $500. It expires on December 20. By that date, you can sell the shares at this specified price or you can simply 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.
Buying put options is the opposite of buying call options. Generally, when you buy a call option, you are bullish on the price of the underlying asset. A call option gives you the right to purchase shares at the strike price. So the more the price of the stock increases above the strike price, the more money you can make. Buying a put option, on the other hand, is generally a bearish play on the price of a stock.
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 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 then purchase a put option to buy 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 exercise the put and sell 100 shares of XYZ stock for $100 each, or $100 x 100 shares = $10,000.
You can now sell these shares on the open market for $100 per share. 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 this price 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 purchase 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 in addition to buying them, you can also sell them. When you sell put options, you immediately earn the premium price you are paid for the option. Continuing with our XYZ Stock 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 paid to you is now your income to keep. However, the contract obligates you to buy shares of XYZ from the put holder if they decide to 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 ($9000 – $10,000 + 500) / 500 = -$500 / $500 for a 100% loss.
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. Therefore, selling puts can be 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 for $100 apiece 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 can even cut down on some of the risk inherent to short selling.
If you’re interested in learning more about how to trade options, just sign up for our free e-letter Trade of the Day. You’ll learn a lot about call options and puts and the strategies you can use to make money from them.
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.
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.