Put Option: What It Is, How It Works, and How to Trade Them (2023)

What Is a Put Option?

A put option (or “put”) is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified timeframe. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying security at a specified price, either on or before the expiration date of the option contract.

Key Takeaways

  • Put options give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame.
  • Put options are available on a wide range of assets, including stocks, indexes, commodities, and currencies.
  • Put option prices are impacted by changes in the price of the underlying asset, the option strike price, time decay, interest rates, and volatility.
  • Put options increase in value as the underlying asset falls in price, as volatility of the underlying asset price increases, and as interest rates decline.
  • Put options lose value as the underlying asset increases in price, as volatility of the underlying asset price decreases, as interest rates rise, and as the time to expiration nears.

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Put Option Basics

How a Put Option Works

A put option becomes more valuable as the price of the underlying stock or security decreases. Conversely, a put option loses its value as the price of the underlying stock increases. As a result, they are typically used for hedging purposes or to speculate on downside price action.

Investors often use put options in a risk management strategy known as a protective put, which is used as a form of investment insurance or hedge to ensure that losses in the underlying asset do not exceed a certain amount. In this strategy, the investor buys a put option to hedge downside risk in a stock held in the portfolio. If and when the option is exercised, the investor would sell the stock at the put’s strike price. If the investor does not hold the underlying stock and exercises a put option, this would create a short position in the stock.

(Video) Bill Poulos Presents: Call Options & Put Options Explained In 8 Minutes (Options For Beginners)

Factors That Affect a Put’s Price

In general, the value of a put option decreases as its time to expiration approaches because of the impact of time decay. Time decay accelerates as anoption’s timeto expiration draws closer since there’s lesstimeto realize a profit from the trade. When an option loses its time value, the intrinsic value is left over. An option’s intrinsic value is equivalent to the difference between the strike price and the underlying stock price. If an option has intrinsic value, it is referred to as in the money (ITM).

Option Intrinsic Value

Option Intrinsic Value = Difference between Market Price of Underlying Security and Option Strike Price (For Put Option, IV = Strike Price minus Market Price of Underlying Security; for Call Option, IV = Market Price of Underlying Security minus Strike Price)

Out of the money (OTM) and at the money (ATM) put options have no intrinsic valuebecause there is no benefit in exercising the option. Investors have the option of short-selling the stock at the current higher market price, rather than exercising an out-of-the-money put option at an undesirable strike price. However, outside of a bear market, short selling is typically riskier than buying put options.

Time value, or extrinsic value, is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires. Different put options on the same underlying asset may be combined to form put spreads.

There are several factors to keep in mind when it comes to selling put options. It’s important to understand an option contract’s value and profitability when considering a trade, or else you risk the stock falling past the point of profitability.

The payoff of a put option at expiration is depicted in the image below:

Put Option: What It Is, How It Works, and How to Trade Them (1)

Where to Trade Options

Put options, as well as many other types of options, are traded through brokerages. Some brokers have specialized features and benefits for options traders. For those who have an interest in options trading, there are many brokers that specialize in options trading. It’s important to identify a broker that is a good match for your investment needs.

(Video) Put Options Explained: Buying & Selling Put Options

Alternatives to Exercising a Put Option

The buyer of a put option does not need to hold an option until expiration. As the underlying stock price moves, the premium of the option will changeto reflect the recent underlying price movements. The option buyer can sell their option and either minimize loss or realize a profit, depending on how the price of the option has changed since they bought it.

Similarly, the option writer can do the same thing. 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 profit or loss is the difference between the premium collected and the premium paid to get out of the position.

Example of a Put Option

Assume an investor buys one put option on the SPDR S&P 500 ETF (SPY), which was trading at $445 (January 2022), with a strike price of $425 expiring in one month. For this option, they paid a premium of $2.80, or $280 ($2.80 × 100 shares or units).

If units of SPY fall to $415 prior to expiration, the $425 put will be “in the money” and will trade at a minimum of $10, which is the put option’s intrinsic value (i.e., $425 - $415). The exact price for the put would depend on a number of factors, the most important of which is the time remaining to expiration. Assume that the $425 put is trading at $10.50.

Since the put option is now “in the money,” the investor has to decide whether to (a) exercise the option, which would confer the right to sell 100 shares of SPY at the strike price of $425; or (b) sell the put option and pocket the profit. We consider two cases: (i) the investor already holds 100 units of SPY; and (ii) the investor does not hold any SPY units. (The calculations below ignore commission costs, to keep things simple).

Let’s say the investor exercises the put option. If the investor already holds 100 units of SPY (assume they were purchased at $400) in their portfolio and the put was bought to hedge downside risk (i.e., it was a protective put), then the investor’s broker would sell the 100 SPY shares at the strike price of $425.

The net profit on this trade can be calculated as:

[(SPY Sell Price - SPY Purchase Price) - (Put Purchase Price)] × Number of shares or units

Profit = [($425 - $400) - $2.80)] × 100 = $2,220

What if the investor did not own the SPY units, and the put option was purchased purely as a speculative trade? In this case, exercising the put option would result in a short sale of 100 SPY units at the $425 strike price. The investor could then buy back the 100 SPY units at the current market price of $415 to close out the short position.

The net profit on this trade can be calculated as:

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[(SPY Short Sell Price - SPY Purchase Price) - (Put Purchase Price)] × Number of shares or units

Profit = [($425 - $415) - $2.80)] × 100 = $720

Exercising the option, (short) selling the shares and then buying them back sounds like a fairly complicated endeavor, not to mention added costs in the form of commissions (since there are multiple transactions) and margin interest (for the short sale). But the investor actually has an easier “option” (for lack of a better word): Simply sell the put option at its current price and make a tidy profit. The profit calculation in this case is:

[Put Sell Price - Put Purchase Price] × Number of shares or units = [10.50 - $2.80] × 100 = $770

There’s a key point to note here. Selling the option, rather than going through the relatively convoluted process of option exercise, actually results in a profit of $770, which is $50 more than the $720 made by exercising the option. Why the difference? Because selling the option enables the time value of $0.50 per share ($0.50 × 100 shares = $50) to be captured as well. Thus, most long option positions that have value prior to expiration are sold rather than exercised.

For a put option buyer, the maximum loss on the option position is limited to the premium paid for the put. The maximum gain on the option position would occur if the underlying stock price fell to zero.

Selling vs. Exercising an Option

The majority of long option positions that have value prior to expiration are closed out by selling rather than exercising, since exercising an option will result in loss of time value, higher transaction costs, and additional margin requirements.

Writing Put Options

In the previous section, we discussed put options from the perspective of the buyer, or an investor who has a long put position. We now turn our attention to the other side of the option trade: the put option seller or the put option writer, who has a short put position.

Contrary to a long put option, a short or written put option obligates an investor to take delivery, or purchase shares, of the underlying stock at the strike price specified in the option contract.

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Assume an investor is bullish on SPY, which is currently trading at $445, and does not believe it will fall below $430over the next month. The investor could collect a premium of $3.45per share (× 100 shares, or $345) by writing one put option on SPY with a strike price of $430.

If SPY staysabove the $430strike price over the next month, the investor would keep the premium collected ($345) since the options would expire out of the money and be worthless. This is the maximum profit on the trade: $345, or the premium collected.

Conversely, if SPY movesbelow $430 before option expiration in one month, the investor is on the hook for purchasing 100 shares at $430, even if SPY falls to $400, or $350, or even lower. No matter how far the stock falls, the put option writer is liable for purchasing the shares at the strike price of $430, meaning they face a theoretical risk of $430 per share, or $43,000 per contract ($430 × 100 shares) if the underlying stock falls to zero.

For a put writer, the maximum gain is limited to the premium collected, while the maximum loss would occur if the underlying stock price fell to zero. The gain/loss profiles for the put buyer and put writer are thus diametrically opposite.

Is Buying a Put Similar to Short Selling?

Buying puts and short selling are both bearish strategies, but there are some important differences between the two. A put buyer’s maximum loss is limited to the premium paid for the put, while buying puts does not require a margin account and can be done with limited amounts of capital. Short selling, on the other hand, has theoretically unlimited risk and is significantly more expensive because of costs such as stock borrowing charges and margin interest (short selling generally needs a margin account). Short selling is therefore considered to be much riskier than buying puts.

Should I Buy In the Money (ITM) or Out of the Money (OTM) Puts?

It really depends on factors such as your trading objective, risk appetite, amount of capital, etc. The dollar outlay for in the money (ITM) puts is higher than for out of the money (OTM) puts because they give you the right to sell the underlying security at a higher price. But the lower price for OTM puts is offset by the fact that they also have a lower probability of being profitable by expiration. If you don’t want to spend too much for protective puts and are willing to accept the risk of a modest decline in your portfolio, then OTM puts might be the way to go.

Can I Lose the Entire Amount of the Premium Paid for My Put Option?

Yes, you can lose the entire amount of premium paid for your put, if the price of the underlying security does not trade below the strike price by option expiry.

I’m New to Options and Have Limited Capital; Should I Consider Writing Puts?

Put writing is an advanced option strategy meant for experienced traders and investors; strategies such as writing cash-secured puts also need a significant amount of capital. If you’re new to options and have limited capital, put writing would be a risky endeavor and not a recommended one.

(Video) Options Trading for Beginners (The ULTIMATE In-Depth Guide)

The Bottom Line

Put options allow the holder to sell a security at a guaranteed price, even if the market price for that security has fallen lower. That makes them useful for hedging strategies, as well as for speculative traders. Along with call options, puts are among the most basic derivative contracts.

FAQs

What is a put option How does it work? ›

A put option gives you the right, but not the obligation, to sell a stock at a specific price (known as the strike price) by a specific time – at the option's expiration. For this right, the put buyer pays the seller a sum of money called a premium.

How do you work out a put option? ›

To calculate profits or losses on a put option use the following simple formula: Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration.

How do you get max profit on a put option? ›

Maximum profit

The maximum potential profit is equal to the strike price of the put minus the price of the put, because the price of the underlying can fall to zero.

What happens if I buy a put option? ›

Buying a put option gives you the right to sell a stock at a certain price (known as the strike price) any time before a certain date. This means you can require whoever sold you the put option (known as the writer) to pay you the strike price for the stock at any point before the time expires.

How much do you lose on a put option? ›

Potential losses could exceed any initial investment and could amount to as much as the entire value of the stock, if the underlying stock price went to $0. In this example, the put seller could lose as much as $5,000 ($50 strike price paid x 100 shares) if the underlying stock went to $0 (as seen in the graph).

What is the downside of buying a put option? ›

Investor A purchases a put on a stock they currently have a long position in. Potentially, they could lose the premium they paid to purchase the put if the option expires. They could also lose out on upside gains if they exercise and sell the stock.

What is a $5 put option? ›

Example of a put option

By purchasing a put option for $5, you now have the right to sell 100 shares at $100 per share. If the ABC company's stock drops to $80 then you could exercise the option and sell 100 shares at $100 per share resulting in a total profit of $1,500.

When should I buy a put option? ›

Investors may buy put options when they are concerned that the stock market will fall. That's because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset goes down.

When should you sell a put option? ›

Selling put options at a strike price that is below the current market value of the shares is a moderately more conservative strategy than buying shares of stock normally. Your downside risk is moderately reduced for two reasons: Your committed buy price is below the current market price.

Can you get rich selling put options? ›

Selling puts generates immediate portfolio income to the seller, who keeps the premium if the sold put is not exercised by the counterparty and it expires out of the money. An investor who sells put options in securities that they want to own anyway will increase their chances of being profitable.

What increases the value of a put option? ›

Put option prices are impacted by changes in the price of the underlying asset, the option strike price, time decay, interest rates, and volatility. Put options increase in value as the underlying asset falls in price, as volatility of the underlying asset price increases, and as interest rates decline.

What happens if I buy a put option and the stock goes down? ›

A Put option locks in the selling price of a stock. So if you buy an option with a strike price of $70 this will allow you to sell the stock for $70 anytime between the day you buy the option and when it expires. So if the stock falls to $60 your Put option will go up in value.

What happens if you sell a put option early? ›

Early exercise happens when the owner of a call or put invokes his or her contractual rights before expiration. As a result, an option seller will be assigned, shares of stock will change hands, and the result is not always pretty for the seller.

Can you get out of put option early? ›

A put option is out of the money if the strike price is less than the market price of the underlying security. The holder of an American-style option contract can exercise the option at any time before expiration.

What happens if you sell a put option in the money? ›

When you sell a put option, you agree to buy a stock at an agreed-upon price. Put sellers lose money if the stock price falls. That's because they must buy the stock at the strike price but can only sell it at a lower price. They make money if the stock price rises because the buyer won't exercise the option.

What is the max risk of selling a put option? ›

Maximum risk

Risk is limited to an amount equal to stock price minus strike price plus put price plus commissions. In the example above, the put price is 3.25 per share, and stock price minus strike price equals 0.00 per share (100.00 – 100.00). The maximum risk, therefore, is 3.25 per share plus commissions.

Can you lose unlimited money on puts? ›

Here's the catch: You can lose more money than you invested in a relatively short period of time when trading options. This is different than when you purchase a stock outright. In that situation, the lowest a stock price can go is $0, so the most you can lose is the amount you purchased it for.

Are puts safer than calls? ›

Neither is particularly better than the other; it simply depends on the investment objective and risk tolerance for the investor. Much of the risk ultimately resides in the fluctuation in market price of the underlying asset.

Should I buy a call or put option? ›

If you are playing for a rise in volatility, then buying a put option is the better choice. However, if you are betting on volatility coming down then selling the call option is a better choice.

Why is my put option losing money? ›

When the price of the underlying stock goes up, the put option will lose value. Put options also become less valuable as time passes. Part of the value of an option is time value, which slowly “evaporates” as the expiration date approaches.

What does a $25 put mean? ›

Selling a put option with a strike of $25 means if the price falls below $25 you will be required to buy that stock at $25, which you wanted to do anyway.

How much cash do you need to sell puts? ›

If the put is assigned, you'll be obligated to buy 100 shares of XYZ at $50. In order to be cash-secured, you'll need at least $5000 in your account. Since you've already received $94.40 from the sale of the put, you only need to come up with the additional $4905.60 ($5000 minus $94.40). How might this trade pan out?

How does making money on puts work? ›

A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.

How far out should you buy puts? ›

Note. It's wise to buy options with 30 more days until expiration than you expect to be in the trade, to mitigate the loss of value.

What happens if I don't close my put option? ›

As such, if the contract is not acted upon within the expiry date, it simply expires. The premium that you paid to buy the option is forfeited by the seller. You don't have to pay anything else.

Why would you buy a put option? ›

Investors may buy put options when they are concerned that the stock market will fall. That's because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset goes down.

Why would someone sell a put option? ›

Selling puts generates immediate portfolio income to the seller, who keeps the premium if the sold put is not exercised by the counterparty and it expires out of the money. An investor who sells put options in securities that they want to own anyway will increase their chances of being profitable.

When would you buy a put option? ›

An investor would buy a put option if they expected the underlying futures contract price to move lower (decrease by the sell date). For example, if you buy a United States 12 Month Oil Fund (USL) July 22 put, you're purchasing the right to sell the contract at $22 (your "strike price") before July.

What happens at the end of a put option? ›

When a put option expires in the money, the contract holder's stake in the underlying security is sold at the strike price, provided the investor owns shares. If the investor doesn't, a short position is initiated at the strike price.

What is a put option example? ›

Example of a put option

By purchasing a put option for $5, you now have the right to sell 100 shares at $100 per share. If the ABC company's stock drops to $80 then you could exercise the option and sell 100 shares at $100 per share resulting in a total profit of $1,500.

What happens if I buy a put option and the stock goes up? ›

A put option becomes more valuable as the price of the underlying stock or security decreases. Conversely, a put option loses its value as the price of the underlying stock increases. As a result, they are typically used for hedging purposes or to speculate on downside price action.

How long is a put option good for? ›

A put option gives you the right to sell at your strike price of $100 within those three months, even if the stock price falls below that amount.

Should I let my put option expire? ›

Is It Better to Let Options Expire? Traders should make decisions about their options contracts before they expire. That's because they decrease in value as they approach the expiration date. Closing out options before they expire can help protect capital and avoid major losses.

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