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How a Put Option Works

What is a put option

Key Points

  • Put options are a powerful tool for investors and traders to lock in profits.
  • Put options are one of two derivative trading vehicles available to equity traders.
  • A put option is a contract to sell a stock at a certain price, otherwise called “putting” the stock back to its previous price point.

This is where to find out more about put options. Put options are a powerful tool for investors and traders to lock in profits, hedge against downturns, and provide incredible leverage in a trading account. Put options are among the many market tools that provide liquidity and aid price discovery, allowing investors to profit even when the market is moving lower. 

This article aims to provide an in-depth look into a put option and how investors can use it to profit. When you finish this article, you will know what you need to know to take the next step in your options trading career. 

Decoding Put Options

Put options are one of two derivative trading vehicles available to equity traders. An option or stock option is a contract between an issuer, usually a seller, and the holder or buyer. A put option is a contract to sell a stock at a certain price, otherwise called “putting” the stock back to its previous price point. 

Put options differ from call options in that call options are a contract to buy a stock at a set price. In this scenario, the holder of a call option might profit if the underlying stock price increases, whereas with a put option, the holder will profit if the stock price decreases. Put options and call option contracts can be bought or sold depending on the investor and circumstance. 

There are several terms that options traders should be aware of, including strike price, expiration, option chain, In-the-money, at-the-money, out-of-the-money, delta and theta. 

  • Strike price: The strike price is the contract price, not the price of the contract, and is the price at which the holder may sell stock. This is important for determining profits.
  • Expiration: Put Options are a time-sensitive instrument granting the holder the right to sell stock for a limited time. Each option contract comes with an expiration date that may be as short as 1 day or as long as several years.
  • Option Chain: The option chain is a table of options contracts for each optionable stock. The option chain includes a list of strike prices organized by expiration, with puts and calls normally listed in columns side by side. The option chain includes the option symbol, the strike prices, the bid/ask, and other recent pertinent trading statistics.
  • In-the-Money: Put Options can have 2 kinds of value: time value and intrinsic value. Time value is the price or premium you pay to buy the option. That may be compounded by intrinsic value, the difference between the stock and option strike prices. If the put option strike price is above the underlying stock price, it has positive intrinsic value and is called In-the-money. Options that expire in the money expire with value. If the strike price is $20 and the stock price is $18, the put option has $2 of intrinsic value. 
  • At-the-Money: At-the-money options have a strike price equal to or very close to the options' strike price. These options have little to no intrinsic value and whatever time value is associated with the expiration. Options that expire at the money expire worthless or with very little value. 
  • Out-of-the-Money: Out-of-the-Money options are Put Options with a strike price below the stock’s price. These are usually the cheapest options and provide the biggest returns, but they also come with the most risk. Options that expire out of the money expire worthless. 
  • Option Delta: Option Delta is an advanced concept traders can use to gauge which option to buy or sell. The Option Delta is expressed as a figure between 0 and 1 and measures how much movement in the underlying asset it takes for the option price to increase by $1. Naturally, options with a higher Delta gain value quickest while those with lower Delta gain value the slowest and are the most risky for buyers. 
  • Option Theta: Option Theta is another advanced concept and part of the Options Greeks. Theta measures time decay and is expressed as a  negative number. An option with a Theta of -0.15 loses a $0.15 value daily. The sting is that Theta increases every day, including weekends and gains momentum as expiration gets closer. In-the-money options with longer expiry tend to have lower Theta and higher Delta than other options. 

Mechanics of Put Options

Every Put option contract can be bought or sold to open, which can be confusing. Traders who want to buy a Put will buy to open their position, while those who wish to sell an option will sell to open. Closing a position is exactly the opposite and would be sold to close for a Put option buyer and buy to close for a put option seller. This is how it works:


Bob owns stock XYZ and sees the market setting up for a downturn. XYZ is a stock position Bob has been building for years and does not want to sell; he’s waiting for another dip to buy more and wants to take advantage of oncoming market weakness. This is what he does. 

Options contracts control 100 shares of stock. A single contract of stock XYX controls 100 shares of the underlying asset and is priced per share. A contract of XYZ may be listed at $3.20 per share, which results in a net cost or premium of $320 per contract- because Bob owns 1000 shares of XYZ, he wants to buy 10 contracts to hedge his position. 

To open the position, Bob enters a brokerage account, finds the options chain, and picks a slightly out-of-the-money put option with 2 months until expiration. The cost is $320 per contract or $3200 for the position. He enters the order as a Buy-To-Open for 10 contracts at a limit of $3.20 good-until-cancelled. His order is quickly filled. 

Company XYZ issued weak guidance two weeks later, and shares fell 15%. Because Bob bought Put options, the options contracts increased in value. His contracts doubled in price to $640, providing $320 in profits or $3200 for the position. To close the position, he entered the order as Buy-to-Close, but he could have made the option seller buy his shares at the strike price. This is called exercising the option. In this scenario, his stock position fell, but the option gain offset the loss. 

Selling to Open a Put Position

In the first scenario, Bob chose to buy a Put option rather than sell 1, but selling was a viable option. Assuming the same conditions, this is how it would work: 

Bob wants to hedge his position and is preparing to buy more of stock XYZ if there is a price correction. Instead of buying a Put option to hedge the position, he sells 1. In this scenario, option assignment happens when the stock price falls. Bob sold to open his position and must buy the stock when the option owner decides to exercise his position. 

What does this mean for Bob? It means he must buy the stock at the strike price, which may produce a loss given the decline in share prices. However, in return, Bob received the option premium for selling the option, so he has that money to offset the difference. In this scenario, Bob hedged his underlying position by taking advantage of the market downturn and bought the stock he would buy at a lower price. 

The attraction of this strategy is that the market may still need to correct. In that case, the Put option may have expired worthless, and Bob would pocket the $3200 in option premium. Because he sold with 1 month of expiry, he’s free to do the same thing again once the option expires. More advanced options traders may buy and sell a put to hedge the existing position and capture more stock at a lower price.

Pricing and Valuation of Put Options

As we have discussed, options have 2 types of value: intrinsic and time value. The intrinsic value is the cash value of the option relative to the underlying asset. If the put options strike is above the stock price, the option has intrinsic value. Time value is the price you pay to hold the options and increases as the time to expiry increases. 

These values can be easily determined using simple math and an Options Profit Calculator. Options calculators are based on the Black-Scholes Model but often produce “wrong” information. Why is that? The answer is volatility. Equity markets are driven by fear and greed, which influence price movement and, more importantly, the expectation for price movement, affecting option prices. 

Expected price movement in a stock is implied volatility or IV. IV is determined based on the pricing for options and can be used to measure fear and greed. When IV is high, options prices will be higher than normal, and the opposite is true when IV is low. This means the implied volatility can help determine the best options to buy or sell. A buyer of puts would want to buy low IV and sell high, while a put option seller would want to sell high IV and buy low. 

Strategies and Real-world Applications

Here’s a quick look at some real-world applications and strategies for Put option traders. 

  1. Speculation: Options provide an easy and less expensive means for short-term traders and speculators to gain exposure to equity markets. As we have seen, put options can be used for bearish and bullish speculation. 
  2. Leverage: Put options provide a less-expensive means to gain exposure to a market, which can be used to leverage an account. If 100 shares of stock cost $1000, an options contract to control those shares may cost $100 or less, depending on the stock, strike, expiration, and IV. In this case, an options trader could leverage that $1000 into 1000 shares or 10X the exposure of simply buying the stock. 
  3. Protective Put: A protective put is used to hedge an existing position like investor Bob did in the 1st example. Protective puts are often used to protect against upcoming news events or other foreseeable events that may produce a sharp market downturn. 
  4. Bullish Speculation: The 2nd example with investor Bog is a form of bullish speculation. Bob wished to buy stock XYZ, but only after a price correction. He sold a put speculating the stock would not correct within the next month, or, if it did, he would use the option premium to offset the cost of buying the stock at the strike price. 
  5. Bear Put Spreads: A bear put spread is similar to a covered call or bull call spread except in reverse. The trader buys a put at a higher strike and sells 1 at a lower strike to capture downward movement in the stock price with a hedged position. 

Risks and Considerations 

The risks of Put options trading are considerable and include losing 100% of the option position. Options that expire out of the money expire worthless, and even an in-the-money option may provide no profit. 

The 2 primary risks are time decay and leverage. Because options lose value each day, and the loss accelerates over time, it may take a substantial movement in the underlying asset price just to maintain a constant price in the option. If the IV also changes significantly, it may be impossible to profit from the position regardless of the underlying movement. 

Options provide leverage, but leverage is a 2-edged sword. If a stock option’s Delta is 0.5, it gains $0.50 for each dollar gain in the underlying asset, but it will also lose $0.50 for each dollar loss. As Delta declines to 0, the loss per dollar movement will accelerate and quickly drain the value from the options. A general rule of thumb is that options that lose more than 50% of their value are unlikely to rebound and provide profits. 

All options traders must read and acknowledge receipt of an ODD or Options Disclosure Statement. This statement is also known as The Characteristics and Risks of Standardized Options

Conclusion

Put options are an important part of market mechanics and dynamics that every trader should know. Options provide leverage, are a means to hedge positions, and can enhance returns over time. Knowing the risk of options trading is critical to using them wisely, which means adequate due diligence and money management techniques. If you have what it takes to trade options successfully, the time to learn more is now. 

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