What is a put option?
A put option, or “put,” is a regulation contract that gives the owner (buyer) the right to sell (sell short) an underlying security at a fixed price within certain time frames. The strike price is the price at which a put option holder can sell their underlying security.
Put options are traded against all other underlying assets, like stocks, currencies, bonds, commodities, etc. The put option is the opposite of a call option, which gives its owner the right to buy an underlying security at a specified price, either on or before option expiration.
KEY TAKEAWAYS
- A put option is a contract that gives the holder the right to sell a specific quantity of an underlying security at an agreed-upon exercise price during part of or through all of its life.
- We can buy put options on stocks, indexes, commodities, and currencies.
- The price of put options changes with the value of the underlying securities, and this, in turn, is impacted by factors such as time decay, strike prices, interest rates, and volatility.
- Appreciation of put options occurs as the underlying asset price falls, volatility in the underlying asset price increases, and interest rates fall.
- Whenever the underlying price goes up, the volatility of the underlying comes down, in case interest rates are on the rise, or whenever expiration nears, put options lose value.
How a Put Option Works
If the price of an underlying stock or security decreases, a put option increases in value, whereas if the same asset goes up and rises on its strike prices, then that particular put option becomes nil. That is why they are generally used for hedging or speculation on the downside.
Investors use protective puts as a type of risk management strategy, almost like taking out insurance or hedging, to ensure that their losses in underlying securities do not exceed a specified amount. In this case, the investor buys a put option to hedge the downside risk of the stock he holds in his portfolio.
If and when the stock drops below this strike price, also on the exercise of the option, then the investor would sell at that put’s strike price. When exercising a put option without having an underlying on the stock, you may trigger opening up a short position in that same underlier.
Put Price Determinants
More specifically, a put option will gradually lose value with time due to its time decay, which reduces the price as the expiration date approaches. This time decay also increases as a trade gets closer to the expiration date of an option since there are fewer and fewer meaningful trades that can be profitable with enough extra weeks allowed for price fluctuations.
Intrinsic value is whatever remains of an option after the time element has been priced out. The difference between the underlying stock price and the strike price of a call option is termed intrinsic value. Shopping: The should statement “Must Have” options trade as ITM.
Important: 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)
If you were to exercise either of these two options, there would be no advantage to doing so; accordingly, they have neither intrinsic value nor intrinsic value. An alternative for investors is the choice to short that stock at an immediately higher mkt price vs. exercising the OTM put option at an undesired price. However, in all conditions, apart from a bear market, shorting shares is typically riskier than acquiring puts.
The value of time is also called extrinsic as it impacts the premium of an option. For example, if a put option has an exercise price of $20 and the stock is trading at $19, then there’s intrinsic value to that particular option in there. On the other hand, that option might be trading for $1.35. That 35 cents is an added time value because the stock price could move in another direction before option expiration. Put spreads are made up of different strike prices on the same underlying asset.
Reasons to sell put options: How much value and profit an option contract has is mostly the most important part of deciding whether to consider a trade or not; otherwise, you would have stock fall way past your break-even point.
The payoff of the put option at expiration is shown in the figure below:
Where to trade options
Most other options, and put options are no exception, are traded via entities known as brokerage firms. Some of the other brokers also claim reserve features and benefits for option trading. Many brokers are available for people who intend to trade options. You will need to locate a broker suited for your investing purposes.
Put Option Exercise Alternatives
You see, when you are a put option buyer or holder, it does not mean you need to hold onto the contract until expiration. The premium of the option will be adjusted depending on how much change occurred in the underlying price recently because there have been some changes made to these kinds of models again due to their re-touching on call and price harvesting from different tech levels.
Now the buyer of that option may sell his option and either realize a profit or limit losses up to where the price went down. The same can also be done by the option writer. If the index price is weaker than the strike, they don’t exercise it. The reason is that the option has a chance of expiring worthless, so they could get to keep all that premium.
On the other hand, if the underlying options start trading toward or up above their strike price, the option writer will have to buy back his short options as quickly as possible. This takes him out of the position, and profit or loss is essentially just the difference between one premium collected and another paid to get out of the position.
Example of a Put Option
Consider a long-term investor that has bought one put option on the SPDR S&P 500 ETF, priced at $445 (Jan. tensile strength of black oxide-coated Grade B7 steel-2022), with an exercise/strike price of $425 expected to expire within four weeks. Let us say this particular option has a premium of $2.80, which would equal buying the right at $280 ($2.80 x 100 shares). Say SPY is trading at $415 by the expiry date.
If the $425 is now “in the money” (it will be trading at a minimum of $10), that means it already contains some intrinsic value—the difference between what you could sell shares for elsewhere and at your put strike price ($415). The specific price for the put would be contingent upon many factors, but one of the largest determining factors is time to expiration (!). LIC: If the $425 put is trading at 10.50
As this put is now “in the money,” there are 2 options for that investor: (a) exercise their right to sell 100 shares of SPY at $425, or (b) sell out of that put option, which would be a profit. We discuss both cases: (i) when an investor already has 100 units of SPY; and (ii) when he does not have any such units. For simplicity purposes, we will ignore the commissions in the following:.
If the investor exercises the put option—in other words, if the investor already owned 100 contracts of SPY purchased at $400 in its portfolio and bought a put to hedge against decline—then the broker would sell his client’s shares for him automatically by exercising a strike price of $425.
This trade’s net profit can be calculated as:
[(SPY’s sell price minus SPY’s purchase price) minus the purchase price of the put] x the number of shares or units
Profit = [($425 – $400) – $2.80] × 100 = $2,220
What if the investor never owned the SPY units and the put was bought purely as a speculative trade? If the investor does exercise the put option here, he will end up selling 100 units of SPY at $425. He can square off this short by buying back 100 SPY units at the present market price of $415.
This net profit on the trade can be computed as follows:
[(SPY short sell price – SPY purchase price) – (Put purchase price)] × No. of shares or units
Profit = [($425 – $415) – $2.80] × 100 = $720 Exercising the option, selling the shares, and then repurchasing them is a somewhat complicated undertaking, 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 has a more straightforward “option.” Sell the put option at its current price and make a tidy profit. The profit calculation in this case is:
[Sell Price, Buy Price] × Number of shares or units = [10.50 – $2.80] × 100 = $770
There’s something important to notice here. Selling the option, instead of going through the comparatively complicated process of exercising the option, actually produces a profit of $770, which is $50 more than the profit of $720 from exercising the option. Why the difference? Because selling the option captures the time value of $0.50 per share ($0.50 × 100 shares = $50), most long option positions that have value before expiration are sold rather than exercised.
Thus, the maximum loss in an option position for a put buyer is restricted only to the premium paid for the put. In this case, if the underlying stock price drops to zero, there would be a maximum gain in an option position.
Writing Put Options
We talked about put options in the last section from a buyer’s perspective, or just an investor who has long puts. At this point, the focus turns to the opposing side of that option trade: the put option seller or writer who takes a short position in = an out-of-the-money (OTM) put.
Unlike with a long put option, an investor who buys or writes (sells) a put is not required to own the underlying stock.
For example, if an investor thinks SPY shares trading at $445 will not fall below $430 during the next month,. Writing a one-put option on SPY with a strike price of $430 would allow the investor to collect a premium of $3.45 per share × 100 shares, or approximately $345.
In one month, if SPY is still trading above $430, the options will have expired out-of-the-money, and Hedgehog Man would keep all of that sweet premium; his cost to open this spread was a mere $345. This is the highest profit on the trade: $345 or payoff collected
However, if SPY drops below $430 before the options expire in a month, and it is assumed that will happen, he has to buy 100 shares at $430, even though what matters in this instance would be whether or not the price of those same 30 days later was trading for less than $400, $350, or lower.
For example, if that same underlying goes to zero no matter how low the stock goes, they would have an obligation to buy at a $430 strike price (so-called “at-the-money put”), and as such, their theoretical risk is: $430 = 43k per contract.
The upside in the case of the put writer is limited to the premium received, but at the same time, the downside can be zero (i.e., when the price goes down), which will result in maximum loss for such a strategy. As a result, the profit/loss profile of the put buyer is exactly opposite that of the option writer.
Q: What is a put option example?
Ans: Here is an example of a put option:
For example, Investor X purchases a put option on the stock of Company ABC at an exercise price (the so-called strike) of $50 with maturity after 3 months. If the ABC stock is currently trading in the market at $55 and X has a put option, then that means that X holds insurance against losing value for its
ABC stocks with clearly stated conditions: the right but not obligation to sell one share of Company-ABC stock on demand from another party within the next 3 months paid by the price set as equal to $50 per share. For example, if the stock price drops to $45 before expiration X, he exercises his put option and can sell that same share for $50, for a profit of $5 per share. However, as long as the stock price is at least $50, X can elect not to exercise the put and let it expire.
What is the difference between a short and a put?
A short sale involves selling a stock that you do not own with the expectation of buying it back later at a lower price to make a profit. A put option, on the other hand, gives the buyer the right to sell the stock at a specified price (strike price) before the option expires. The key difference is that a short sale involves selling a stock without owning it, while a put option involves buying the right to sell the stock.
What is the 3-30 formula?
There is no specific “3-30 formula” mentioned in the context of options. However, the 3% and 30% rules are general guidelines for stop-loss orders. The 3% rule suggests setting a stop-loss at 3% below the current price, while the 30% rule suggests setting it at 30% below the current price. These rules help manage risk by limiting potential losses.
Why sell a call option?
Selling a call option, also known as writing a call option, involves selling the right to buy the underlying stock at a specified price (strike price). This strategy is often used to generate income from the premium received for the option. It is beneficial when you expect the stock price to remain stable or decline.
How do I calculate the option profit?
To calculate the profit from an options trade, you need to know the current stock price, the strike price, the option price (premium), and the number of contracts. The profit is calculated by subtracting the strike price and option price from the current stock price and multiplying it by the number of contracts.
What is OI in options?
OI stands for open interest. It represents the total number of outstanding contracts in an option. It is an important indicator of market activity and can help traders gauge the liquidity and volatility of an option.
Are they bullish or bearish?
The puts are bearish. They are used to profit from a decline in the underlying stock price. The buyer of a put option expects the stock price to fall below the strike price, allowing them to sell the stock at the higher strike price.
What is a stop-loss order?
A stop-loss order is a type of order that automatically sells security when it falls to a certain price, known as the stop price. This helps to limit potential losses by automatically selling the security when it reaches a predetermined level.
What is a put-and-call option?
A put option gives the buyer the right to sell the underlying stock at a specified price (strike price), while a call option gives the buyer the right to buy the underlying stock at the specified price. These options are used to manage risk and generate income from the premium received for the option.
Why buy a put option?
You buy a put option to profit from a decline in the underlying stock price. The buyer of a put option expects the stock price to fall below the strike price, allowing them to sell the stock at the higher strike price.
When should I buy call options?
You buy a call option when you expect the underlying stock price to rise above the strike price. The buyer of a call option expects the stock price to increase, allowing them to buy the stock at the lower strike price and sell it at the higher market price.
How does it work?
It puts work into it by giving the buyer the right to sell the underlying stock at a specified price (strike price). If the stock price falls below the strike price, the buyer can exercise the option to sell the stock at the higher strike price, resulting in a profit.
When should I sell the put option?
You sell a put option when you expect the underlying stock price to remain stable or rise above the strike price. This strategy is often used to generate income from the premium received for the option.
What happens when a put expires?
When a put option expires, it becomes worthless if the stock price is above the strike price. If the stock price is below the strike price, the buyer can exercise the option to sell the stock at the higher strike price, resulting in a profit.
Are calls or puts better?
The choice between calls and puts depends on your market expectations. If you expect the stock price to rise, you should buy a call option. If you expect the stock price to fall, you should buy a put option.
What to buy today, call or put?
The decision to buy a call or put option depends on your market expectations. If you expect the stock price to rise, buy a call option. If you expect the stock price to fall, buy a put option.
What is the price?
The put price is the price at which you can buy a put option. It is also known as the premium.
What is the call-and-put option with an example?
A call option gives the buyer the right to buy the underlying stock at a specified price (strike price), while a put option gives the buyer the right to sell the underlying stock at the specified price. For example, if you buy a call option with a strike price of $50 and the stock price is $60, you can exercise the option to buy the stock at $50 and sell it at $60, resulting in a profit.
What is an example of buying a put?
Buying a put option involves paying a premium for the right to sell the underlying stock at a specified price (the strike price). For example, if you buy a put option with a strike price of $50 and the stock price is $40, you can exercise the option to sell the stock at $50, resulting in a profit.
What is called buy and sell?
Buying a call option involves paying a premium for the right to buy the underlying stock at a specified price (the strike price). Selling a call option involves selling the right to buy the underlying stock at the specified price. For example, if you buy a call option with a strike price of $50 and the stock price is $60, you can exercise the option to buy the stock at $50 and sell it at $60, resulting in a profit.
How does a call option work?
A call option works by giving the buyer the right to buy the underlying stock at a specified price (strike price). If the stock price rises above the strike price, the buyer can exercise the option to buy the stock at the lower strike price and sell it at the higher market price, resulting in a profit.
How do I buy a put option?
To buy a put option, you need to know the current stock price, the strike price, and the option price (premium). You can buy a put option through a brokerage firm or an online trading platform.
How do I exercise a put option?
To exercise a put option, you need to have the option in the money (i.e., the stock price is below the strike price). You can exercise the option by contacting your brokerage firm or online trading platform and instructing them to exercise the option.
What is OI in the option chain?
OI stands for open interest. It represents the total number of outstanding contracts in an option. It is an important indicator of market activity and can help traders gauge the liquidity and volatility of an option.
What is a good PE ratio?
A good PE ratio depends on the industry and the company. Generally, a lower PE ratio indicates that the stock is undervalued, while a higher PE ratio indicates that the stock is overvalued.
When to sell PE?
You sell a PE (put option) when you expect the underlying stock price to rise above the strike price. This strategy is often used to generate income from the premium received for the option.
Why sell puts vs. buy calls?
Selling puts and buying calls are both strategies used to generate income from options. Selling puts involves selling the right to sell the underlying stock at a specified price, while buying calls involves buying the right to buy the underlying stock at a specified price. The choice between the two strategies depends on your market expectations.
What is the difference between short-selling and puts?
Short selling involves selling a stock that you do not own with the expectation of buying it back later at a lower price to make a profit. A put option, on the other hand, gives the buyer the right to sell the underlying stock at a specified price. The key difference is that short selling involves selling a stock without owning it, while a put option involves buying the right to sell the stock.
What is the risk of selling puts?
The risk of selling puts is that you may be obligated to buy the underlying stock at the strike price if the buyer exercises the option. This can result in a loss if the stock price is higher than the strike price.
Is selling a put bullish?
No, selling a put is bearish. It involves selling the right to sell the underlying stock at a specified price, which is beneficial if you expect the stock price to rise above the strike price.
Is it better to buy puts or sell short?
The choice between buying puts and selling shorts depends on your market expectations and risk tolerance. Buying puts involves buying the right to sell the underlying stock at a specified price, while selling shorts involves selling a stock that you do not own. Both strategies can be used to profit from a decline in the stock price, but they have different risks and rewards.
