What is a put option? Definition, examples and trading strategies

Investors can use put options to make money on the downward price movement of a stock or other security.

What are put options and how do they work?

A put option is an options contract that grants its buyer the right (but not the obligation) to sell a specific quantity (usually 100 shares) of an asset (like a stock) at a specific price no later than on the expiration date of the contract. .

In return for this right, the buyer of the option pays a premium to the seller of the option. A put option is considered a derivative security because its value is derived from the value of an underlying asset (eg, stocks). Investing in a put option is like betting that the price of a stock will fall before the expiration of the put contract. In other words, put options are generally bearish investments.

Put options versus call options

Put options are the opposite of call options. While put options give their owners the right to to sell something at a specific strike price, calls give their owners the right to to buy something at a specific strike price.

A long investor bets on the fall in value of a security (which would allow him to sell shares at a price higher than its value or to sell the contract at a price higher than what he paid), while that a long investor is betting on the value of a falling security (which would allow them to buy shares at a price lower than their value or to sell the contract at a price higher than what they paid) .

How can you make money on a put option?

Investors can realize gains on put options in two ways: resell or exercise.

Each option has a premium (market value) for which it can be bought and sold, and this premium changes over time depending on factors such as the intrinsic value of the contract (the difference between the strike price of the contract and the market price of the underlying asset), the time remaining until expiration and the volatility of the underlying asset.

To make a profit, an options trader might buy a put option for a security that he thinks will go down in value. If this happens, the option’s premium will increase and the contract holder can sell the option back for their new, higher premium, pocketing the difference between the price they sold it for and the price they sold it for. bought.

Alternatively, an investor could buy an options contract with a strike price at or above the market price of an underlying security in the hope that the security will lose value. If the price of the underlying security falls, the option holder can exercise the option and sell shares at the strike price, which is higher than the market price of the underlying asset.

It is important to remember here that the premium an investor pays for a contract is part of its cost basis and should be considered when deciding to sell or exercise an option for profit. Options investors only make a profit if their earnings exceed the premium they paid for the option contract in question.

How to Trade Put Options

Options such as put options can be traded through the most popular trading platforms such as Charles Schwabb, Robinhood, WeBull and Fidelity. Generally, however, investors should seek approval from their brokerage before beginning to trade options. Options can also be traded directly, and not through a broker, in the over-the-counter (OTC) market.

3 Common Sell Negotiation Strategies

There are many ways to trade put options, but the following three strategies are some of the most common.

1. Long Bet

A long sell is probably the simplest selling strategy. If an investor is bearish on a stock (i.e. they think its value will go down), they can buy a put option on it. If they choose an option whose strike price is higher than the market price of the underlying asset (i.e. an out-of-the-money option), no intrinsic value will be included in the premium of the contract.

TheStreet Dictionary Terms

If the stock in question declines in value before the contract expires, the option would gain intrinsic value as it moves in the money, and the investor can either resell it at a profit or exercise it in order to sell stock. of the underlying stock for more than they are worth.

2. Put bare or uncovered

A naked sell is actually a bullish strategy. If an investor identifies a stock they would like to own (i.e. something they believe has long-term value regardless of short-term price volatility) and which they believe will increase in value at short term, he can write or sell a put option on this stock. The buyer of the put option thinks the price of the underlying stock will go down, but the seller wants it to go up.

If the value of the underlying stock rises (above the strike price), it expires worthless and the seller pockets the contract premium. If the value of the underlying stock drops, the buyer can choose to exercise the contract, which would result in the seller buying 100 shares above market value.

Remember here that the seller wrote the put on a stock they like long-term, so despite the fact that they took a loss buying 100 shares for more than market value, they don’t mind own the shares because they believe the market value of the shares will increase in the long term.

3. Put protection

A protective put option is actually a risk mitigation strategy for an investor who is long on a real stock (or other security). In other words, if an investor owns a stock and thinks its value will rise, he can buy put options on that stock (a contract for 100 shares he owns) with strike prices equal to the price that paid for the actual shares of stock they own (or less, depending on their loss tolerance).

If the value of the stock in question goes up (as the investor thinks), their stock goes up in value, but they lose the premiums they paid for the sales contracts. This is not a big deal, as premiums are not as expensive as the actual assets from which they derive their value.

If, on the other hand, the value of the stock in question falls below the strike price of the contracts, the investor can simply exercise their contracts and sell their shares at the strike price. If the strike price they chose was the same as their purchase price, they don’t lose any money apart from the premiums paid for the contracts.

Essentially, a protective put option is an insurance policy that an investor buys to prevent large losses that could occur if a stock they own loses significant value.

Why do investors buy put options?

Many investors find put options attractive because they do not require a large amount of upfront capital. In effect, put options allow a trader to profit from the downward movement of a stock’s price (in increments of 100 shares) without buying the stock itself.

Additionally, risk is limited, because the most an options buyer stands to lose is the premium or cost of the options contract itself, not the full value of the underlying stock. Shorting a stock is similar to buying a put option in that it is a bet that the stock price will fall.

Essentially, put options allow bearish traders to bet on price declines without having to buy, borrow, or sell actual stocks, which requires more capital and carries more risk.

How do you know if a put option is in-the-money (ITM) or out-of-the-money (OTM)?

Options that have intrinsic value are considered “in-the-money”, while options that do not are considered “out-of-the-money”. A put option is in-the-money and has intrinsic value if its strike price is above the market price of the underlying asset (also known as the spot price).

For example, a put option with a strike price of $60 and a spot price of $50 would be in the money $10 because if exercised immediately, the resulting shares could be sold for a gain of $10. . In other words, this particular sales contract would have an intrinsic value of $10 because it grants its owner the right to sell shares for $10 more than they are worth.

Intrinsic value is always included in an option’s premium, so there would be no point in buying a put in the money just to exercise it immediately, because its premium would embed its intrinsic value, so no gain would be realized. If an investor purchased the notional put option discussed above, they would do so in the expectation that the price of the underlying asset would continue to fall, causing the intrinsic value of the option to exceed the premium he paid before exercising or reselling the contract.

Buying a put or short selling a stock: what’s the difference?

If an investor buys a put option, they pay a premium for each of the 100 shares included in the contract, so if the contract expires out of the money (worthless), they only lose the premium they paid.

In a short sale, on the other hand, an investor borrows real stock to sell (hoping to buy it back at a below-market price later before returning it to the lender), so if the stock goes up significantly instead of going down they stand to lose a lot more money. Essentially, potential losses on a put option are capped by the put option’s premium, whereas losses on a short position are not because they depend on how much a stock’s price rises before to have to return it.

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