In our comprehensive article about call and put options, we provided an overview on options investing.
In this article we will go into more detail about how put options work and some examples of how you would use puts in your investment plan.
What is a Put
A put option is simply the reverse of a call option in that a put gives the put owner the right to sell stock at a specific price(the strike) for a limited time.
To define put option more technically it is a contract giving the owner the right but not the obligation to sell a specified amount of an underlying security at a specific price within a specified time.
Only active stocks have options traded on them. The more active a stock, the more choices there are in different strike prices and expiration periods for that stock.
By buying a put, you are not obligated to to exercise it. It simply is a contract that gives you the right to sell a stock at a specific price by a specified time period.
The put seller is required to buy the stock at the strike price if the put is exercised by the buyer.
A put buyer is bearish on a stock as they want the stock price to drop. Whereas a put seller is bullish on the stock so they want the stock to rise. A rising price allows the put seller to keep the premium if the stock stays above the strike price.
Each put option has a specific strike price and expiration date. If the stock drops below a put option strike price then that option is called “in-the-money”. In-the-money means the put buyer can exercise the option and sell(“Put”) the stock to the option seller at the specific strike price which is higher than the current stock price..
Before moving on, it is important to define put option risk and reward. The maximum profit for a put option buyer occurs if the stock goes to zero. The maximum loss for a put buyer is the cost (“premium”) of the put option if the put expires worthless.
Image Source: Wikipedia Long Put Option Graph
Put Options Example For a Buyer
If you bought a put for $1.00(actual cost would be $1.00 x 100 = $100) that had a strike price of $30 then your largest profit potential is if the stock goes to zero would be $30-1 = $29 x 100 = $2900
If the stock doesn’t move below the strike price of $30 then the put option expires worthless and you lose $100.
The math for determining profit on puts is:
Strike price - Current stock price - Premium paid = Profit.
You can close your put position early before expiring and the profit would be the difference between premium paid from buying the put options minus the premium received from closing the put position.
Put options can also be implemented as a seller to generate income or combined with other selling strategies.
Also, buying put options can be a less complicated alternative to short selling a stock when you think a stock is going to drop in price.
What is put option buying most common strategy ?
For put buyers, the most common strategy is called protective put buying. This strategy involves simply buying puts to defend against a drop in the value of stocks that you currently own.
What is Put Option Risk ?
A put buyer’s biggest enemy is time value as puts options will erode in value as they get closer to expiration.
Besides time value, puts also erode in value if volatility drops because it means there is less likelihood that the stock will move.
When buying or selling options it is important to understand volatility. Certain expiration periods with above average volatility like quarterly earnings can cause large losses on put options.
High volatility increases put option prices which can cause put buyers to overpay for a put option.
High volatility can also signify a future event is coming and can keep put sellers from experiencing potential large losses that can occur with riskier strategies like naked put selling.
A decrease in volatility for near-term options premiums frequently happens after a company releases earnings. A volatility decrease can benefit option sellers but hurt a put option buyer.
A put option buyer might have paid a large put premium before earnings betting that the stock would drop but if the stock doesn’t drop enough to offset the drop in volatility then they could still lose money on the put even if they were correct on the direction of the stock move.
In this article we explained in more detail what is a put and gave more insight into the risk/reward and what to consider when using put options.
Overall, put options if used correctly can be used for a wide range of investment strategies.
For more understanding, watch this video overview on put options explained
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