How a Put Option Works

Posted on Friday, September 21st, 2018 MarketBeat Staff

“Buy low and sell high” is considered a fundamental commandment of investing. But there are times when an investor can profit from a stock even when it’s moving down. In these cases, an investor can issue what’s called a put option.

Put options require an investor to be familiar with the concept of options trading. Trading options sometimes get a bad reputation, but it's really nothing more than a strategy in which an investor gives themselves the "option" to take a particular buying or selling action for a fee that is paid by the owner of the option and collected by the other party. One of the simplest strategies of options trading – and one that typically carries minimal risk – is the put option.

This article will go into detail about what a put option is and why one may be used. When you’re finished reading, you should have a better understanding of put options and whether you would like to put this strategy to work in your portfolio.

What is a put option?

A put option is a financial contract between a buyer and a seller. While every put option is a little different based on the value of the underlying stock, the concept is the same. The owner of the put (in this case the seller) buys the right, but not the obligation, to sell the buyer of the contract 100 shares of a given stock at an agreed-upon price on or before the option's expiration date. The fee for this right, known as a premium, is set by the market based on the market value of the stock.

If the stock price falls below the agreed upon price, the owner of the option may exercise his right. At this point, the buyer must purchase the seller’s shares at the agreed upon price. In this way, the owner of the put profits from selling their shares above current market value.

If the stock price does not fall below the agreed upon price, the owner of the option can simply choose to let the option expire. In this case, the seller is only out the money he paid to purchase the put option.

When explaining put options, the terms “buyer” and “seller” can get confusing. With a put option, the owner of the put is the seller. To help simplify this, it can be helpful to contrast a put option with its opposite strategy, a call option.

  • A call option is a buying action initiated by an investor who is looking to purchase a call option. This makes the prospective buyer the owner of the option.
  • A put option is a selling action initiated by an investor who is looking to sell a put option. This makes the prospective seller the owner of the option.

Related terms to help better understand put options

Using simple English, like in our example above, can sometimes be useful to help explain investing concepts. However, when you get in front of a broker or other financial professional, they will probably call things by their proper name. Here are some definitions of frequently used terms related to put options.

Strike price – this is the target price specified in the put option. This is the minimum price that a seller will use when considering whether or not to pick up the option they purchased.

Expiration date– the last date the option can be left open. On or before this date, the buyer of the put option must exercise the option. If the option is not exercised, it is allowed to expire. The expiration date is fixed as the 3rdFriday in the month that the option is expiring.

Premium – this is, essentially, the transaction fee for the options contract. In the case of the put option, it provides a hedge against risk by the seller of the put option should the option expire without being used. The price of the premium is set based on the value of the stock. In the case of a put, as the stock price falls, the premium goes up. The important thing to remember about a premium is that for the buyer of the option, this is the only capital that they are truly putting at risk in the event they decide not to exercise the option.

In the money – a term used to describe a put option that would be worth more than $0 if sold on the open market.

At the money– a term used to describe a put option where the market price of the stock is the same as the strike price

Although this is not a term, it’s also important to know that one put option contract covers 100 shares of the stock.

What is required to transact a put option?

Every transaction requires a buyer and a seller. So, in this case, a prospective seller of a stock needs a buyer. In some cases (which we’ll review later), the seller may be attempting to execute a put option without actually owning the stock in question. To execute this strategy, called a naked put (or short put), the seller (in most cases) will be required to have enough funds in his brokerage account to cover the cost of the shares plus the premium cost (along with any commissions he will have to pay on the trade).

What are the reasons investors use put options?

The basic reason investors use put options is when they own a stock that they speculate may go down in value. Another reason is that they want to set a floor for a particular stock or stocks they own. This may be particularly beneficial if they are nearing a retirement goal, such as retirement and want to lock in their gains. One of the benefits of using a put option, ironically, is in the event the stock does not decrease in value. If the owner of the stock sells at the current price, they would miss out on any capital gains if the stock goes up. By using a put option, they can simply allow the option to expire and the only capital they would have put at risk is the cost of the option.

How a put option works

When discussing trading strategies like put options, it’s better to illustrate better than to tell. So here’s an example that can help make the process, and the profit potential, clear. 

An investor owns shares in Cisco Systems which is trading at $40 a share. They speculate that the stock may drop due to disappointing earnings. So they issue a put option with a strike price of $38 set to expire the following month (so the third Friday of that month). Let’s say the premium for this option is set at $1/per share (so the cost to the seller would be 100x1 = $100). They now have the right, but not the obligation, to sell their Cisco shares at the price of $38 by the expiration date. Let’s review three possible scenarios to show what can happen.

Scenario #1 – the stock price plunges below the strike price to $36. In this case, the owner of the option (the seller) would “put” the option to the buyer who would buy the seller’s 100 shares of Cisco for $38 per share. This would give the seller $3800 – the premium ($100) for a total of $3,700.

Although they would be making $300 less than they would have if they had simply sold the shares at $40, they would still have made more than if they did not have the put option and had to sell the shares at $36. You can also see where a put option can reduce the downside risk of owning a stock. In this example, there’s theoretically no limit to the depth that this stock may fall. So by setting a put option, an investor is setting a floor for the stock price.

Scenario #2 – the stock price drops to the strike price but not lower. In this case, the owner of the option may choose to let the option expire and here’s why. If they exercise the option, they would receive $3,800, but because they would also lose their $100 premium, their net gain would only be $3,700. If they had simply sold the stock outright, they would pocket $3,800. So in this case, they may choose to let the option expire, pay the $100 and re-evaluate their strategy for the stock.

Scenario #3 – the stock price rises above the strike price. In this case, the owner of the option would simply let the option expire since at this point there would be no intrinsic value to sell. The investor could then either issue another put option or sell the stock at the higher market value. 

As you can see, put options are pretty straightforward. However, in some cases, if a stock is particularly volatile, the price of the premium may fluctuate quite a bit during the time the option is open. This can have a huge effect on the anticipated profit. However, to mitigate this, an option can be called prior to its expiration date.

Using put options without owning shares

There is a way of using put options when an investor does not own shares in the stock that they want to buy. This is called selling puts. It’s a somewhat risky investing strategy, but it can be profitable and here’s why.  In a “traditional” put option, the investor looking to sell their shares is buying a put option and therefore they are required to pay the premium. In this strategy, the investor is selling a put option to a buyer (somewhat similar to a call option) and collecting the premium. Also, when using a strategy of selling, the trade is only profitable if the stock price rises or falls no lower than the strike price; whereas in a traditional put the investor is speculating that the stock will drop below the strike price.

So in our example above, let's say an investor was eager to purchase stock in Cisco Systems, but they felt $40 per share was too high. They would, however, be willing to buy the shares at $37. In this case, they could sell a put with a strike price of $37. If the stock reaches that price, they would simply buy the shares at $3,700, which is what they wanted to do anyway, and they would have collected the premium so they would have actually purchased the shares at a discount. If the share price rises above $40, the contract would expire worthless and they would still have the premium.

Of course, the risk involved with this strategy is that the stock price could fall well below the strike price. So in our example, if the price of Cisco's stock fell to $35, an investor would be required to sell their shares to the buyer at the strike price of $3,700. Since they don't actually own the shares, they would first have to purchase the shares and then sell them. In this case, their loss would be the difference between what they paid for the shares and what they sold them for, in this case, $200. So even though they made a premium, this would be a losing trade.

In many cases, investors who sell puts are executing what is called cash-secured puts. This requires them to have enough money in their brokerage account to cover a potential loss. A more risky kind of strategy is the naked put where the investor borrows money on margin from a broker's account in order to cover any loss if the put is exercised.

The last word on put options

Options trading is not for everyone, but it can be a profitable trading strategy. Put options are an options trading strategy that investors use when they are speculating that a stock may go down in price but still provides them with a hedge that comes from holding on to the stock if the price goes up.

In most cases, an investor will buy a put option, but in some cases, an investor can profit from selling puts. In this strategy, an investor writes a put option without actually owning the stock.

 

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