Put Option Explained

July 13, 2017 0
Graph showing the potential profit/loss of the long put option strategy at expiration.

What are Put Options?

A put option is a financial contract that gives the buyer the right, but not the obligation, to sell an underlying security (like a stock, futures contract, currency, etc.) at a specific price at any time until the contract expires.

Traders can buy-to-open a put option as well as sell-to-open.

A put that is bought-to-open is known as a long put. And a put that is sold-to-open is known as a short put.

As a buyer of a put option contract, i.e. a long put, you only have the right to sell the appropriate amount of the underlying security if the put option is in-the-money, but you never have the obligation.

Therefore, a seller of a put option contract, i.e. short put, always has the obligation to sell the appropriate amount of the underlying security if the short put option is in-the-money.

 

How a Put Option Works

Put options for most US stocks, futures, and indices are also known as plain vanilla options and fall under two categories: American Style Options and European Style Options. Almost all stock options in the US are American Style. Some index options, like SPX and NDX, are European Style.

American style options can be exercised at anytime prior to expiration, assuming the option is in-the-money.

European style options can only be exercised at the expiration date of the option contract, assuming the option is in-the-money.

For a stock, 1 put option equates to 100 shares.

For a futures contract, 1 put option typically equates to 1 futures contract.

 

How Traders Use Put Options

Traders primarily use put options for three reasons: speculation, hedging, and reducing cost-basis.

Speculation: Buying puts in anticipation of the underlying asset decreasing in value prior to expiration is known as speculation. This is a risky trade, because if the underlying asset (like a stock or futures contract) does not decrease in value before expiration, the purchased put options will expire worthless. Similarly, traders can sell a put option in anticipation that the underlying asset will not decrease prior to expiration resulting in the put option will expire worthless. Option sellers profit on the premium collected.

Hedging: It is also common practice to buy put options as a hedge against a potential decrease in the underlying asset. This is one of the most common ways long investors hedge their positions. Essentially, buying a stock and buying a put is the same as shorting a stock and buying a call.

Reducing Cost Basis: Covered puts are a common way traders use put options and reduce their overall cost basis if they are short a stock. If a trader is short 100 shares of XYZ at $50, for example, he can sell 1 out-of-the-money put option at any strike price contract against his existing short shares. Assuming he sells a $45 put option for $0.80, he will keep the full $80 in premium unless XYZ is below $44.20 at expiration. If XYZ is below $44.20 at expiration, the trade will still produce a net profit of $580. No matter what happens, the trader gets to keep the $80 in put option premium.

 

Basic Strategies Involving Put Options

Because a put option can either be bought or sold to initiate a trade, there are a variety of options trading strategies traders can take advantage of with puts.

In addition to long puts and short puts, there are put debit spreads and put credit spreads, which are essentially hedged variations of buying and selling puts.