What are put options? How do put options work and how does it help me profit when stock price goes down?
Put Options - Definition
Put Options are stock options that gives its holder the POWER , but not the obligation , to SELL the underlying stock at a FIXED PRICE by a fixed EXPIRATION DATE .
Put Options - Introduction
Put Options are the least understood of the 2 kinds of stock options. The other being Call Options that give you the right to buy the underlying stock for a fixed price. Put Options enable you to sell the underlying stock at a price fixed right now no matter how low it falls in future. That said, rarely are put options really used as a tool to sell your stocks but as a tool to capture value as the underlying stock drops and then sell the put options at a profit! Apart from being an incredibly flexible and risk limited leverage instrument, Put Options are fantastic hedging instruments for any stock portfolios.
Put Options allow investors to do something relatively unfamilar to the stock trading world and that is, to profit from a downturn in stocks without getting into margin calls or shorting anything. Shorting stocks exposes the investor to unlimited upside risk whereas buying put options puts at risk nothing more than the price you paid for the put options! There is no shorting needed! No shorting, No margin, Limited Loss and Unlimited profits is what sets the buying of Put Options apart from shorting stocks!
How Do Put Options Work?
Put Options are financial contracts between a buyer and a seller. The seller or "writer" of Put Options is giving the Buyer of those Put Options the right to sell to him stocks at a price fixed and agreed upon in the Put Options contract. The buyer or "holder" of these Put Options can now hold on to them, hoping that the stocks will drop in price over time, before the Put Options contract expires, and then either sell the Put Options on to another buyer at a higher price or buy the stocks at the prevailing market price and then exercise the right vested in the Put Options to sell the stock to the seller at the higher agreed price, turning a profit.
The buyer of those Put Options is clearly expecting those same stocks to go down and is willing to pay a small price to speculate on such a move. This expectation is also captured in the popular investor sentiment indicator known as Put Call Ratio. Put Call Ratio is the ratio of the amount of put options traded versus call options traded.
Parties in Put Options Transaction
Here's an example of what happens in a Put Options transaction:
Put Options ExampleXYZ company shares are trading at $40 right now. $40 strike price Put Options are trading at $2.00. John expects XYZ company shares to go down and shorted 100 shares of XYZ company at $40. Peter expects XYZ company shares to go down too and bought 1 contract of Put Options of XYZ company (representing 100 shares) for $200. John lost $3000 (($70 - $40) x 100) from the rally. Scenario 2 : XYZ Falls To $30 During Expiration Of The Put Options John made $1000 (($40 - $30) x 100) from the drop. Peter made $800 ((($40 - $30) x 100) - 200) from the same drop in net profit after deducting the price of the Put Options, which is a 400% profit! |
Put Options - Terminology
Strike Price
The price at which you can sell shares of the company no matter how far it has moved in the future. Learn More About The Strike Prices.
Holder
Owners of Put Options. You are the holder of your Put Options.
Writer
Sellers of Put Options. You are a writer when you initiate a position by selling Put Options. This is called Sell To Open. Learn More About The Types Of Options Orders. Learn More About Selling Put Options with infographic and video.
Exercise
To initiate the right to sell the underlying stock at the strike price. Learn More About The Exercising Options.
Expiration date
The date by which you must exercise the right to buy shares of the company or let the Put Options laspe worthless. Learn More About The Options Expiration.
In The Money
When the shares of the company is lower than the strike price. Read more about In The Money Options.
At The Money
When the shares of the company is the same as the strike price. Read more about At The Money Options.
Out Of The Money
When the shares of the company is higher than the strike price, making the Put Options worthless upon expiration. Read more about Out Of The Money Options.
Put Options And Time Decay
Put Options contracts come with a price. That price acts as an "insurance premium" to the buyer and a form of compensation to the writer for taking on the extra risk. The longer the expiration date of the Put Options, the higher this price is due to the extra risk the writer is facing. This price is known as the " extrinsic value". As extrinsic value of stock options in general is a function of how long the period of risk the writer is facing governed by the expiration date, it reduces as expiration date approaches. This reduction in value over time is known as Time Decay and is governed mathematically by the Option Greek known as Theta.
Holders of Put Options need to be aware that if the underlying stock fails to move down quickly and hopefully overtaking the price paid on the Put Options, those Put Options would reduce in price daily due to time decay. Writers of Put Options need to be aware of whether or not the extrinsic value of the Put Options that you wish to write justifies the additional risk or fulfills your hedging objectives.
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Please note that this is the practise in the United States. Different countries could have different regulations. |
Applications Of Put Options
There are 2 primary investment functions of Put Options; Leveraged Speculation and Hedging.
Leveraged Speculation
Stock options are great leverage tools that not only produce leveraged, unlimited profits but also limited losses. Put Options are stock option's solution to providing leveraged returns on falling stocks. Put Options allow its holder to benefit from the same profit as in shorting the underlying stock using only a small amount of the money and without needing margin nor risking unlimited losses.
Hedging
Like stock futures, stock options were initially created as hedging instruments. Today, Put Options continue to be excellent hedging instruments used by investment institutions and individuals alike. Put Options can be bought to hedge against a pullback in long stock portfolios and can be shorted to hedge against a lift in short stock portfolios. Apart from that, Put Options can also be creatively longed or shorted to hedge against any kind of options strategies. Put Options produce hedging through Delta Neutral as well as Contract Neutral hedging.
Put Options Trading Strategies
There are many options trading strategies involving the use of Put Options. Here are some of them:
Protective Puts
Protecting and sealing in profits in stocks without selling those stocks.
Bear Put Spread
Profits from a moderate drop in the underlying stock by having short Put Options cover the cost of long Put Options.
Calendar Put Spread
Profits when the underlying stock falls moderately or remains stagnant through buying and writing Put Options of different expiration dates.
Naked Put Write
Profit when the underlying stock remains stagnant or rises moderately by shorting Put Options.
See a full List Of Options Strategies.
Put Options can also be combined with stocks to create call options synthetically without closing the Put Options position. It can also be used to transform stock positions into Put Options or call options synthetically without closing the original stock position. This is known as Synthetic Positioning.
Pricing Of Put Options
The price of Put Options consists of 2 components. The intrinsic value and the extrinsic value. Intrinsic value is the amount of profits already built into the Put Options while the extrinsic value is the price you pay just to own the options contract as a compensation to the seller or writer for the extra risk. When you purchase At The Money options, where the strike price of the Put Options is exact the same as the prevailing price of the stock, or Out Of The Money Options, where the strike price of the Put Options is higher than the price of the prevailing price of the stock, the price of the Put Options would consist of only extrinsic value.
Put Options Pricing ExampleXYZ company shares are trading at $50 right now. $50 strike price Put Options are trading at $2.00. $51 strike price Put Options are trading at $2.80. $49 strike price Put Options are trading at $0.50. The $50 strike price Put Options consists of $2.00 extrinsic value and no intrinsic value as there are no profits built into them yet. This is known as At The Money. The $49 strike price Put Options consists of $0.50 extrinsic value and no intrinsic value as the stock needs to drop below $49 to make a profit. This is known as Out Of The Money. The $51 strike price Put Options consists of $1.80 extrinsic value and $1.00 intrinsic value as the options allows the stock to be sold at $1 higher than the prevailing price. The value of $1 is captured as intrinsic value. This is known as In The Money. |
As you can see from the above example, the price of Put Options is affected mainly by where it's strike price is in relation to the price of the underlying stock. This is known as Options Moneyness and is the most important concept to understand in options trading. Read more about How Stock Options Are Priced. Trading Put Options of different strike prices produces very different results on the same move in the underlying stock. To learn these different considerations, please read the Long Put Options strategy.
Prices of Put Options of different strike prices and expiration dates are presented as Options Chains. Here is how typical options chains looks like:
| XYZ Company, $50, Expiration : Dec 2007 | ||||||
| Symbol | Strike | Last | Bid | Ask | Volume | Open Interest |
| .xyzhg | $49 | $0.50 | $0.30 | $0.50 | 1000 | 50 |
| .xyzhh | $50 | $2.00 | $1.80 | $2.00 | 3000 | 1000 |
| .xyzhi | $51 | $2.60 | $2.60 | $2.80 | 50 | 5 |
Symbol : Every Put Options are identified uniquely with their own names or representations.
Strike : The strike price of each individual Put Options.
Last : The last transacted price of that particular Put Options contract.
Bid : The price at which you can sell a particular Put Options contract at.
Ask : The price at which you can buy a particular Put Options contract at.
Volume : The number of transactions that took place for each individual Put Options contract for the day.
Open Interest : The number of open positions floating in the market for each individual Put Options contract.
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Last price data is not as meaningful in options trading as it is in stocks trading. Stocks can only move in price when a
transaction takes place and that price is reflected in its last price. This means that, for stocks, the last price is
representative of the fair market value of the stock at the prevailing point in time. However, options do not need any
transactions to take place for its value to move. Its value changes as long as the underlying stock price changes.
This makes its last price a very useless piece of information as the price of the option might have moved quite a bit from
the last time it got transacted. That is why options traders only look at the bid and ask price during options trading.
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You get to choose from different expiration months (the month on top) and from different strike prices. Each of these strike price allows you to sell the underlying stock at the strike price no matter what price the stock is in the future. If you buy the $51 strike call option (known as the December 51 Call) for $2.80 (yes, you always buy at the "Ask" price and sell at the "Bid" price), you get to buy the XYZ Company shares at $51 at anytime even is it is trading at $50 now.
Of course, you will never make any money by buying the December 51 put option now, buy XYZ company shares at $50 and then exercising the put option by selling it immediately at $51. Why? Because you would make only $1 out of that sale while you would have paid $2.80 to buy that put option contract. Yes, that difference in price, known as the extrinsic value, has already been priced into the put option and that is why you can see from the chains above that it gets more and more expensive as the put option strike price becomes higher and higher.
Learn More About Volume And Open Interest Of Stock Options.
Get free options chains here.
Where Can You Buy Put Options
You can trade Put Options of any optionable stocks online through the internet simply by opening an account with any online options trading brokers. Put Options are also trade in Over The Counter (OTC) markets or what is known as pink sheets for stocks that do not have exchange traded options. However, these markets are not generally accessible to the public. Exchange traded options are stock options that are publicly traded in the exchanges just like stocks.
Put Options Trading Order
The concept of profiting when the underlying stock falls led a lot of beginners who had some experience with stock trading to think that put options need to be shorted through a Sell To Open order in order to profit when the stock goes down. This is wrong. Put options are options that you BUY in order to profit when the stock goes DOWN, which means that it should be bought with a Buy To Open order like you would buy call options. When a Sell To Open order is used for put options, you are selling put options to people who are speculating that the stock will go down and if it does, you stand to lose money when those put options becomes in the money. You would Sell to Open put options in order to speculate that the stock will go UP, not down and that is known as a Naked Put Write options strategy.
Benefits Of Put Options
:: Able to profit from falling stocks without needing margin.
:: Can be used to hedge against stock or options trading positions.
:: Extremely flexible. Can emulate payoff of stocks or put options through synthetic positions.
Disadvantages Of Put Options
:: Expires worthless if the stock trades above strike price by expiration.
Put Options Questions
:: Do I have to buy stocks in order to buy put options?
:: What is the formula to calculate call and put options price?
:: Why not out of the money put options for married put?
:: Using Protective Put as hedge for ETFs?
:: Exercising Put Options Without Assets?
:: Is Writing Put Options Speculating or Hedging?
:: Will Put Options Have Intrinsic Value Without Stock Dropping?