The right to sell but not the obligation
In short:
A put option is a financial instrument that provides the buyer the right but not the obligation to sell an underlying asset at a set price within a certain timeframe. In financial markets, typical underlying assets are stocks, bonds, and commodities.
Essentially, buying a put option is betting that the stock, bond, or commodities price will decrease. Conversely, selling a put option, called writing an option, is a bet that the stock, bond, or commodities price will not decrease.
Key Points
- A call option provides the option owner the right but not the obligation to sell an underlying stock or asset at a set price within a certain timeframe.
- The value of a put option is dependent on the value of the underlying asset. If the underlying asset increases in value, the put decreases in value.
- All options, including put options, lose value as time progresses.
In-depth:
Understanding Put Options
Okay, so what exactly is a put option?
Let’s say we are a bit bearish on a certain stock, meaning we think it’s very likely the stock will decrease in value. Since this is the case, we have a few options on what we can do:
- We could do nothing, in which case we cannot make any money and the stock is irrelevant.
- We could short sell the stock, meaning we sell shares of the stock we don’t own and plan to buy them back once the share price decreases (high risk).
- Or we could buy a put option which gives us the right to sell the shares at a certain price at some point in the future (low risk).
A standard put option contract for stocks consists of 100 shares. Therefore, if we choose to buy a put option, we are buying the right to sell 100 shares of stock at the price and within the timeframe specified by the options contract.
The price the buyer of the option has the right to sell the shares at is called the strike price. The day the options contract ends is called the expiration date.
In exchange for selling us the right to sell the shares, the option seller collects a fee called the option premium. This is the price we, the buyer, must pay for the put contract and is the maximum amount we, the buyer, can lose. This means, by buying the put contract, we have defined the maximum amount we can lose if we are wrong and the stock price increases (defined risk).
Essentially, a put option allows us to engage our idea that the stock’s price is going to decrease and limit the amount we can lose if we are wrong.
Uses of Put Options
Put options can be used for a wide variety of hedging, trading, investing or speculating activities. Depending on the objectives of the investor, different strategies may be used.
Put Options for Hedging
A large function of options is for hedging purposes, that is, reducing the risk of loss from market movement. Put options can provide downside protection for put option buyers.
For example, say a commodity trading company just bought a large amount of soybeans and wanted to ensure they wouldn’t lose money if the price of soybeans decreased. In addition to this, the trading company wants to keep upside potential in case the value of soybeans increases. With this scenario the trading company may elect to purchase put options on the soybeans, effectively hedging the price against the downside while still keeping the upside open.
*This is a very diluted example from deeper concepts around futures and options
Put Options for Working Into or Out of a Position
Some more advanced traders and investors may use put options to work into or out of a position. By using options, they may be able to get in or get out at a better price than they would with a traditional purchase or sale.
Getting in example, an investor looking to get into a long stock position (owning shares) may elect to sell puts instead of buying the stock outright. By selling puts, the investor collects a premium from the options contract and if the option is exercised, owns the shares they wanted. If successful, the investor will effectively be buying the shares at a discount (strike minus the premium).
Getting in example, an investor looking to get into a stock short position may choose to buy put option contracts instead of outright selling shares. By using this approach, the short seller can engage a leveraged short position on the stock with defined risk (at worst loses the premium). This allows the investor to test their hypothesis and if they are right, build a short position in the stock from an already profitable level.
*Leverage -all this means is the short seller is controlling a large amount of shares with a small amount of money.
Getting out example, an investor who already has a short position may choose to close out their short position by selling a put option. If and when the put option is exercised the investor’s short position will be closed out when they’re required to buy back the shares. The investor will benefit from the premium they receive for the option.
Put Options for Speculation
There are two basic ways to use put options for speculation.
The first and most straightforward way is to buy put options on stocks with no intention of establishing a short position in the stock*. In this light, the put buyer is solely trying to make a profit from the price movement of the shares with the added benefit of leverage options provide. That is, the put buyer can possibly control many shares at a fraction of their value, the premium.
The second and a bit more complicated approach is an attempt to profit from the change in premium price that comes as a result of the change in the price of the shares. This is more complicated as it can be more volatile and is subject to time decay. That is, as time progresses they lose value since there is less and less time for the option to turn profitable before expiration.
*Why is this speculation? Its assuming full focus is being placed on price movement instead of the actual value of a company.
Long Put Example
Say you were interested in buying American Express (AXP) 170.00 October 8 2021 puts. The current premium is quoted at $1.29 meaning the total premium for 1 standard contract is $129. Additionally, the current price for AXP is $173.94 with 5 days remaining until expiration.
Does buying this put option make money?
Fast-forward to expiration, AXP is now trading at $176.32 meaning the option is out of the money. It would not be wise to exercise the option.
Thankfully the maximum amount you could lose is $129, the price of the premium.
What would the math look like if you did exercise the option? ( $170.00 – $176.32 ) *100 – $129 = -$761.
Is Buying a Put Bullish or Bearish?
Buying a put option would indicate that you’re bearish as the only way to profit from buying a put option comes from a decrease in share price. On the other hand, selling put options indicates you are bullish on the nearer-term future outlook as the main way to profit from this strategy is with an increase in share prices.
Frequently Asked Questions
A put option buyer makes money when the stock price falls below the strike price of the option and far enough to compensate for the put premium. A put option seller makes money when the stock’s shares don’t fall in price.
Why buy a put option? Put options are bought as a hedge against the decline in value of an underlying asset. For a small amount of money, an investor can protect their investment from large losses with a decline in the value of the underlying asset. Put options can also be bought for speculation.
What’s the downside of a put option? For a put buyer, the maximum downside is the price they paid for the premium. For a put seller on the other hand, the possible downside is theoretically the difference between the stock’s price and zero.