Editor’s Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
What Is a Put Option?
In options trading, a put option is the purchase of a contract that gives an investor the right, but not the obligation, to sell a specific security at a certain price by a certain date. Put options are different from call options, the purchase of which gives buyers the right, but not the obligation, to buy a particular security at a certain price by a certain date.
Investors can use put options to trade a variety of securities, including stocks, bonds, futures and commodities. Trading options can potentially lead to greater returns, but it can also amplify losses, making it a potentially riskier strategy.
Understanding certain options terminology — including what a put option is and how it works — can be helpful if you’re thinking about incorporating options trading strategies into your portfolio.
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Options Basics
Before digging into the details of put options, it’s helpful to understand a little about how options trading works in general. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a certain price — this is called the strike price. Options must also be exercised by a specific expiration date.
An investor who buys an options contract pays a premium to do so, which can be determined by the volatility of the underlying asset and the option’s expiration date. If the option holder does not exercise the option by the expiration date, they lose their right to buy or sell the underlying security and the option has no value.
Options are derivative investments, since they derive their value from the underlying assets. They can be bought and sold on an exchange, just like the underlying assets they’re associated with.
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How Does a Put Option Work?
A put option is a specific type of options contract. Here’s an example: The buyer of the put option has the right, but not the obligation, to sell shares of an underlying asset at the agreed-upon strike price up until the option’s expiration date. Meanwhile, the seller of the put option has an obligation to buy those shares from the buyer if the buyer chooses to exercise the put option.
Put options increase in value as the price of the underlying security decreases. Likewise, put options lose value as the price of the underlying stock increases. Depending on where the underlying asset’s price is in relation to a put option’s strike price, the option can be one of the following:
• In the money: An in-the-money put option has a strike price that’s higher than the underlying asset’s price.
• At the money: An at-the-money (or on-the-money) put option has a strike price that’s equal to the underlying asset’s price.
• Out of the money: An out-of-the-money put option has a strike price that’s below the underlying asset’s price.
Of the three, the in-the-money put option is more desirable because it means a put option has intrinsic value. If you’re the buyer of a put option and that option is in the money, it means you can sell the underlying asset for more than what it’s valued at by the market.
Recommended: In the Money (ITM) vs Out of the Money (OTM) Options
Put Option Example
An example might make things even more clear.
Assume you own shares of XYZ stock. The stock is currently trading at $50 a share but you believe its price will dip to $40 per share in the near future.
You purchase a put option which would allow you to sell the stock at its current price of $50 per share. The options contract conveys the right to sell 100 shares of the stock, with a premium of $1 per share.
If your hunch about the stock’s price pays off and the price drops to $40 per share, you could exercise the option. This would allow you to sell each of the 100 shares in the contract for $10 more than what it’s worth, resulting in a gross profit of $1,000. When you factor in the $1 per share premium, your net profit ends up being $900, less any commission fees paid to your brokerage.
Difference Between Put and Call Option
It’s important to understand the difference between put and call options in trading. A call option is an options contract that gives the buyer the right, but not the obligation, to purchase shares of an underlying asset at the strike price by the expiration date. The seller of the call option is obligated to sell those shares to the call option buyer, should they decide to exercise the option.
Like put options, call options can also be in the money, at the money, or out of the money. An in-the-money call option has a strike price that’s below the underlying asset’s actual price. An out-of-the-money call option has a strike price that’s above the underlying asset’s actual price.
Here’s a simple way to think of the differences between put options and call options: With buying put options, the goal is to sell an underlying asset for more than its market value. With buying call options, the goal is to buy an underlying asset for less than what it’s worth.
Pros and Cons of Trading Put Options
Options trading may appeal to a certain type of investor who’s comfortable moving beyond stock and bond trading. Like any other investment, put options can have both advantages and disadvantages. Weighing them both in the balance can help you decide if options trading is something you should consider pursuing.
| Pros | Cons |
|---|---|
|
• Low initial investment required compared to trading stocks. • The option buyer has the right but no obligation to sell the underlying asset. • Higher return potential, on a percentage basis. |
• Losses may be amplified. • The option seller has the obligation to buy the underlying asset at the strike price if the buyer decides to execute the contract, which could result in greater downside for the seller. • Unforeseen volatility may drastically affect price movements. |
Pros of Trading Put Options
• Lower investment. When you purchase a put option, you’re paying a premium and your brokerage’s commission fees. When you purchase shares of stock, you may be investing hundreds or even thousands of dollars at a time. Between the two, put options may be more attractive if you don’t want to tie up a lot of cash in the markets.
Also, buying a put option gives you the right to sell a particular asset at a set strike price but you’re not required to do so. You can always choose to let the option expire; you’d just be out the premium and commission fees you paid.
• Return potential. Trading put options can be lucrative if you’re able to sell assets at a strike price that’s well above their actual price. That might result in a higher profit margin than if you were trading the underlying asset itself.
Cons of Trading Put Options
• Loss amplification. While trading put options can potentially lead to better returns, it can also potentially amplify your losses. If you’re selling put options, you’re obligated to sell the underlying asset at the strike price, even if that strike price is not in your favor.
• Volatility. Volatility can threaten returns with put options if an asset’s price doesn’t move the way you were expecting it to. So it’s possible you might walk away with lower gains than anticipated if you choose to exercise a put option during a period of heightened volatility.
How Do You Trade Put Options?
It’s possible to trade put options inside an online brokerage account that allows for options trading (not all of them do). When deciding which put options contracts to buy, it’s important to consider:
• Where the underlying asset is trading currently
• Which way you think the asset’s price is most likely to move
• How much of a premium you’re willing to pay to purchase an options contract
It’s also important to consider the expiration date for a put option. Keep in mind that options with a longer expiration period may come with a higher premium.
Different Put Option Styles
There’s a difference between European-style and American-style put options.
With European-style options, you can only exercise the option on its expiration date.
With American-style put options you can exercise the option at any time between the date you purchased it and its expiration date, offering more flexibility for the investor.
Put Option Trading Strategies
Different options trading strategies can be used with put options. These strategies vary in terms of reward potential and risk exposure. As you get more familiar with how to trade stock puts, you might begin exploring more advantaged techniques. Here are some of the most common put option plays.
Long Put
A long put strategy involves purchasing a put option with the expectation that the underlying asset’s price will fall. For example, you might want to buy 100 shares of XYZ stock which is trading at $100 per share, which you believe will drop to $90 per share. If the stock’s price drops to $90 or below, you could exercise your contract at the higher $100 per share price point.
Short Put
A short put is the opposite of a long put. In a short put strategy, you’re writing or selling the put option with the expectation that the underlying security’s price will rise or remain above the strike price until it expires. The payoff comes from being able to collect the premium on the option even if the buyer doesn’t exercise it.
Recommended: How to Sell Options for Premium
Married Put
A married put strategy involves holding a long position in an underlying security while also purchasing an at-the-money option for the same security. The idea here is to minimize downside risk by holding both the asset itself and an at-the-money put option.
Long Straddle
A long straddle strategy involves buying both a call option and a put option for the same security, with the same strike price and expiration date. By straddling both sides, you can still end up turning a profit regardless of which the underlying asset’s price moves.
The Takeaway
Options trading may be right for retail investors who are comfortable taking more risk in exchange for a chance to potentially earn higher returns. Getting familiar with put options and how a stock put works is the first step.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
Trade options with low fees through SoFi.
Photo credit: iStock/Drazen_
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