Put Options Explained: What They Are & How They Work
By: Flaka Ismaili November 18, 2021
For a put buyer, if the market price of the underlying stock moves in your favor, you can elect to “exercise” the put option or sell the underlying stock at the strike price. American-style options allow the put holder to exercise the option at any point up to the expiration date. European-style options can be exercised only on the date of expiration. Because put options, when exercised, provide a short position in the underlying asset, they are used for hedging purposes or to speculate on downside price action.
- So far in this module, we have assumed that you as an option buyer or seller would set up the option trade with an intention to hold the same till expiry.
- Otherwise, if you’re interested in understanding how options work so you can use them in your portfolio, here’s what you should know.
- Put options become more valuable as the security decreases in value.
In a put option agreement, the buyer of the put option can buy the right to sell a stock at a price (strike price) irrespective of where the underlying/stock is trading at. Assume an investor is bullish on SPY, which is currently trading at $445, and does not believe it will fall below $430 over the next month. The investor could collect a premium of $3.45 per share (× 100 shares, or $345) by writing one put option on SPY with a strike price of $430. If the underlying price is above the strike price, they may do nothing. This is because the option may expire at no value, and this allows them to keep the whole premium. But if the underlying price is approaching or dropping below the strike price, then to avoid a big loss, the option writer may simply buy the option back (which gets them out of the position).
The time remaining until the option’s expiration influences its value. Generally, options with longer expiration periods tend to have higher premiums. A buyer purchases a 400 put option in XYZ PLC at 20 when the stock was 405. If the stock fell to 350, the buyer would have the right to sell a pre-agreed amount of XYZ stock at 400, giving the option an intrinsic value of 50, up from 20 at the time of purchase. Options move in a non-linear correlation with the underlying asset price, so it is important to choose the right strike for your view. The strike price you choose is the price at which the option can be converted to the underlying asset if you decide to exercise your right.
Options on stocks can be exercised any time prior to expiration, but some contracts—like many index options—can only be exercised at expiration. If the price of the optioned shares in the earlier example fell to $90, the buyer of an uncovered put option could still require the writer to purchase 100 shares for $100 each. After paying the $200 option premium, this put option would earn $800. Buying put options is a way to hedge against a potential drop in share price. They could also reap profits from bear markets or declines in the prices of individual stocks. Derivatives are financial instruments that derive value from price movements in their underlying assets, which can be a commodity such as gold or stock.
Your profit would be $10, but if you were to buy more options, you would multiply your gains (or losses). If the price of the underlying stock falls below the strike price before the expiration date, the buyer stands to make a profit on the sale. The buyer has the right to sell the puts, while the seller has the obligation and must buy the puts at the specified strike price. However, if the puts remain at the same price or above the strike price, the buyer stands to make a loss. The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. For example, if the stock is at $90 and the ABC $95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value.
What is a put option? Understanding how to trade them
In other words, the closer your contract gets to its expiration date, the less time there is for the security to move in one direction or the other. Since potential growth of a stock is limitless, you can say that the profit potential of a protected put is also limitless, minus the premium paid. Following the 2 percent rule, you’ll need to have $65,500 in your trading account for one put option. Multiply this by the number of options you’d like to purchase, and you can see how much capital you’ll need for options trading. Determining how much capital you can allocate to trading options can be challenging.
Alternatives investing
If the price falls, the stock is bought back at the lower price and returned to the broker. A put option allows investors to bet against the future of a company or index. More specifically, it gives the owner of an option contract the ability to sell at a specified price any time before a certain date. Put options are a great way to hedge against market declines, but they, like all investments, come with a bit of risk. For starters, you can lose not only what you invested, but also any chance for profits.
The exercise price is the price that the underlying asset must reach for the put option contract to hold value. There are a lot of stocks out there, but there are exponentially more stock options. Each stock or ETF could have dozens of different options, with different strike prices and durations. This array of different options can lead to low supply and demand for any particular one. This could mean being forced to pay a higher price for an option than you might want to. It can also mean having trouble finding buyers when you go to sell, and having to drop your price to do so.
What you could sell it for depends primarily on the price of the underlying stock. Putting $1 million in a CD is possible, but it requires careful planning to ensure that your investment is safe and aligns with your overall financial goals. It’s crucial to consider the security of your investment, compare rates and diversify your portfolio across different types of accounts and financial institutions.
Buying a Put Option
Maybe a new product is launching and you’re not sure if it’ll be a success. But if it’s a mess, you might expect the price of the underlying stock to fall. Put options are a bit more complex than simply buying and selling stocks or index funds. In most cases, brokerage firms require that investors apply and be approved to buy options.
When you sell a put, you collect a premium from the buyer, and in exchange you agree to buy the underlying stock from the buyer at the strike price — if they exercise the option before expiration. That’s $20 per share more than your strike price, so you wouldn’t want to exercise your put option — you’d just let it expire. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Alternatively, let’s say that you own shares of stock in a company you like. You would prefer not to sell them, but you’re nervous the stock might be ready to decline in price.
As an alternative, you could sell one January $250 put option expiring two years from now for just $30. That means the option will expire on the third Friday of January two years from now, and it has an exercise price of $250. One option contract covers 100 shares, allowing you to collect $3,000 in options premium upfront (less commission). The buyer of a put anticipates the stock price of the option to go down, so they want to lock in the high price before it falls.
What does it mean to buy a put option?
Check out our roundup of the best platforms for options trading. Selling an option at its origin — as opposed to reselling a put or call you originally https://bigbostrade.com/ bought — is also known as “writing” an option. Securities products and services offered through Ally Invest Securities LLC, member FINRA / SIPC .
Placed strategically, a put can save a trader from a loss, or create gains. Think of put options and call options as two sides of the same coin with their respective characteristics trading without stop loss essentially inverted. If an investor feels a stock will rise, they may purchase a call option. One common refrain to help you remember this is “call up and put down.”
