You may be wondering “how does a put option work.” By learning about how they work, you can use them in a variety of trading situations including for speculative purposes to hedging purposes to using them as part of a low risk, high profit option trading strategy. The intent of this writing is about the buy side of a put option rather than on selling “shorting” them.
Let’s now give some background about how put options work and how you can use them for your own trading needs.
Definition Of A Put Option
A put option gives the buyer the right, but not the obligation, to sell a certain amount of an underlying financial instrument (like stocks or ETFs) at a certain price (the strike price) on or before a certain date (the expiration date).
Underlying Equivalency Of Put Options
Put options are expressed in units (or shares) of 100. For example, one put option equals 100 units (or shares) of the underlying financial instrument. Two put options equals 200 units (or shares) of the underlying financial instrument (so on and so forth).
The more put options that you buy the more units (or shares) of the underlying financial instrument that you have the right to sell (or “put”) to someone else – namely the seller of such put options.
Strike Price Of A Put Option
The strike price of a put option is the fixed price inherent in the option’s contract. The strike price governs the price for which the buyer of the put option has the right to sell the underlying financial instrument.
Example: if a put option has a strike price of $30 and the underlying stock price is currently trading at $25, the buyer of such put option has the right to sell the stock for $30 (the strike price). For argument sake, let’s say that only 1 option contract was purchased with initially having 6 months to expiration. Under this scenario, you can exercise your right to sell the stock for $30 and then buy it for its current trading price of $25. Your gain (excluding commissions) is equal to the difference between the two prices or $500 ($30 – $25 = $5 x 100 shares = $500) less the amount paid for the put option say $250, leaving you with a gain of $250. That’s 100% return on your money made sometime within 6 months!
However, instead of selling the stock for $30, you could simply just sell the put option outright to close out your open position and realize the gain that way.
With trading options (whether put options or call options), there are usually many different strike prices available to choose from that are listed on an options chain. This is especially more evident for stocks and etfs that are heavily traded with high volume and liquidity.
Put Option Expiration Dates
You can choose the expiration date of a put option that will best fit your time horizon that you will need it for. For example, expiration dates can be as short as one day to being much longer in time such as several years away which are known as “LEAPS” (Long-term Equity AnticiPation Securities). Of course, you can also pick an expiration date that falls in between these two time frames.
You don’t need to hold the put option to its expiration date, you can sell it at any time on or before its expiration date.
How Put Options React To The Underlying
If the underlying financial instrument falls in price, the purchased put option will gain in value. Conversely, if the underlying financial instrument gains in price, the purchased put option will fall in value.
What Is The Financial Risk
The maximum financial risk for buying a put option is limited to the amount paid for it (the option premium).
Moneyness Of Put Options
Depending on the relationship of the option’s strike price to that of the price of the underlying financial instrument, put options can be classified as follows:
- In-the-money options (I-T-M) – strike price above current underlying price
- At-the-money options (A-T-M) – strike price roughly equal to the current underlying price
- Out-of-the-money options (O-T-M) – strike price below current underlying price
Options that are (I-T-M) will cost more than options that are either (A-T-M) or (O-T-M).
Strategies For Using Put Options
Put options can be used for many interesting trading strategies including:
- Speculative purposes to seek leveraged profits trading the downside of the market
- Creating a multitude of low-risk, high-profit options trading strategies
- Acting as trading or portfolio insurance (hedging) when you are either “long” or “short” the market
In addition, buying put options can also be used as another way to “short” (bearish outlook) an underlying financial instrument instead of actually “shorting” the underlying. This is true since buying put options gain in value as the underlying financial instrument falls in price.
However, unlike “shorting” stocks which carries unlimited financial risk, the financial risk for buying put options is limited to the amount paid for it (the option premium).
