Put options are a type of option that increases in value as a stock falls. A put option allows the owner to set a predetermined price to sell a specific stock, while put option sellers agree to buy the stock at that price. The appeal of put options is that they can appreciate quickly with a small movement in the stock price, and that characteristic makes them a favorite of traders looking to make big profits quickly.
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The other important type of option is the call option. it is the most popular type of option and its price appreciates as the stock rises. (here’s what you need to know about call options).
Reading: What is a put in the stock market
what is a put option?
A put option gives you the right, but not the obligation, to sell a stock at a specified price (known as the strike price) at a specified time, upon expiration of the option. For this right, the buyer of the sale pays the seller a sum of money called a premium. Unlike stocks, which can exist indefinitely, an option is terminated at expiration and then either liquidated, with some value remaining, or with the option’s expiration having no value.
The main elements of a put option are the following:
- strike price: the price at which you can sell the underlying stock
- premium: the price of the option, either for buyer or seller
- expiry: when the option expires and is settled
An option is called a contract, and each contract represents 100 shares of the underlying stock. the contracts are priced in terms of the value per share, rather than the total value of the contract. For example, if the market quotes an option at $1.50, then the cost to buy the contract is $150, or (100 shares * 1 contract * $1.50).
how does a put option work?
Put options are in the money when the stock price is below the strike price at expiration. the owner of the put option can exercise the option, selling the shares at the exercise price. or the owner may sell the put option to another buyer prior to expiration at fair market value.
The owner of a put option makes a profit when the premium paid is less than the difference between the strike price and the stock price at expiration of the option. Imagine a trader bought a put option for a premium of $0.80 with a strike price of $30 and the stock is $25 at expiration. the option is worth $5 and the trader made a profit of $4.20.
If the share price is above the strike price at expiration, the put option is out of the money and expires worthless. the put seller keeps any premium received for the option.
how to buy and sell put options
Buying or selling a put option requires an investor to correctly enter exactly the option they want, including many variables. There are literally dozens of different options for any option value, and you need to know which one you want to buy or sell. These are the key elements of an options trade that you will need to set up:
- underlying security: the stock associated with the option
- option strategy: a call or put option (or even things exotic )
- expiration date: the date the option is settled
- strike price: the price at that the option holder has the right to buy or sell the shares
- premium: the cost of the option
- type of order: market order or limit order
Be especially careful when entering your trade because it is easy to enter an order that is the exact opposite of what you intend to do, which could cost you a lot of money.
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As you place your trade, you’ll also want to consider the break-even price for your trade, i.e. what price the stock must reach before you make money on the option at expiration.
Limit orders are also a must with option trades, to avoid increasing costs. With a limit order, you specify the price you’re willing to accept for a trade, and if the market can’t reach your price, your trade won’t be executed.
advantages of buying put options
Traders buy a put option to increase profits from a stock’s decline. For a small upfront cost, a trader can profit from share prices below the strike price until the option expires. When buying a put option, you typically expect the stock price to fall before the option expires. It can be helpful to think of buying put options as a form of insurance against a stock decline. if it falls below the strike price, you will earn “insurance” money.
Imagine that a stock named wxy is trading at $40 per share. You can buy a stock put option with a strike price of $40 for $3 expiring in six months. one contract costs $300, or (100 shares * 1 contract * $3).
here is a graph of the buyer’s profit when the option expires assuming various stock prices.
As you can see, below the strike price, the option increases in value by $100 for every $1 movement in the stock price. as the stock moves from $36 to $35, a decline of only 2.8 percent, the option increases in value by $400 to $500, or 25 percent.
The option may be in the money, below the strike price, at expiration, but that does not mean the buyer has made a profit. here the premium was $3 per share, so the buyer of the put doesn’t start taking profit until the stock reaches $37, at the strike price of $40 minus the $3 premium. so, in this example, $37 is the trade’s break-even point.
If the stock ends up between $37 and $40 per share at expiration, the put will have some value, but the trader will lose money overall. and above $40 per share, the put option expires worthless and the buyer loses the entire investment.
Buying put options is attractive to traders who expect a stock to decline, and putting options further magnify that decline. therefore, for the same initial investment, a trader can make much more money than shorting a stock, another technique for making money on a stock’s decline. For example, with the same initial $300, a trader could short 10 shares or buy a put option.
if the action ends at $35, then…
- short seller makes a profit of $50, or ($5 decline * 10 shares).
- options trader makes a profit of $200, or the value of the option $500 (100 shares * 1 contract * $5 decline) minus the $300 premium paid on the sale.
This ability to increase potential earnings makes putting options more attractive to some traders than investing in stocks.
why sell a put option?
If you want to trade options, you can buy and sell them. These are the advantages of selling puts. the reward for sellers of put options is exactly the inverse of that for buyers. sellers expect the stock to hold steady or rise above the strike price, rendering the put option worthless.
Using the same example as before, imagine that stock wxy is trading at $40 per share. You can sell a stock put option with a strike price of $40 for $3 expiring in six months. one contract gives you $300, or (100 shares * 1 contract * $3).
This is the seller’s profit at expiration.
As you can see, the profit for the seller of the put option is exactly the inverse of that for the buyer of the put option.
- for a share price greater than $40 per share, the option expires worthless and the seller of the put option keeps the full value of the premium, $300.
- between $37 and $40, the put option is at the money and the put option writer earns part of the premium, but not the full amount.
- below $37, the put option writer sale begins to lose money beyond the $300 premium received.
The appeal of selling puts is that you receive cash up front and you may never have to buy the stock at the strike price. If the stock rises above the strike price at expiration, you will make money. but you won’t be able to multiply your money like you would by buying puts. As a put option seller, your profit is limited to the premium you receive up front.
Selling a put seems like a low-risk proposition, and it often is, but if the stock really does crash, you’ll be forced to buy it at the much higher strike price. and you will need the money in your brokerage account to do so. Investors generally keep enough cash, or at least enough margin capacity, in their account to cover the cost of the stock, if it is put to them. if the value of the stock drops enough, you’ll receive a margin call, forcing you to deposit more cash into your account.
For example, if the stock fell from $40 to $20, a short seller would have a net loss of $1,700, or the $2,000 value of the option less the $300 premium received. But if done wisely, selling put options can be an effective cash-generating strategy, especially on stocks you wouldn’t mind holding if they fell.
put options vs. call options
The other important type of option is called a call option, and its value increases as the stock price rises. so traders can bet on a stock going up by buying call options. In this sense, call options act in the opposite way to put options, although they have similar risks and rewards:
- Just like buying a put option, buying a call option gives you the opportunity to recover many times your investment.
- Just like buying a put option, the risk of buying a call option is that you could lose your entire investment if the call option expires worthless.
- Just like writing a put option, writing a call option earns a premium, but then the seller You assume all risk if the stock moves in an unfavorable direction.
- Unlike writing a put option, writing a call option exposes you to unlimited loss (since a stock can rise at any price but cannot fall below $0). either way, you could lose many times more money than the premium received.
many people think that options are very risky, and they can be, if used incorrectly. But investors can also use options in a way that limits their risk while allowing them to make a profit by going up or down in a stock.