Put Options

What is a Put Option.

A put option is a contract giving the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a pre-determined price within a specified time frame. This pre-determined price that buyer of the put option can sell at is called the strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying at a specified price, either on or before the expiration date of the options contract.

• Put options give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame.

• Put options are available on a wide range of assets, including stocks, indexes, commodities, and currencies.

• Put option prices are impacted by changes in the price of the underlying asset, the option strike price, time decay, interest rates, and volatility.

• Put options increase in value as the underlying asset falls in price, as volatility of the underlying asset price increases, and as interest rates decline.

• They lose value as the underlying asset increases in price, as volatility of the underlying asset price decreases, as interest rates rise, and as the time to expiration nears.

How a Put Option Works

A put option becomes more valuable as the price of the underlying stock decreases. Conversely, a put option loses its value as the underlying stock increases. When they are exercised, put options provide a short position in the underlying asset. Because of this, they are typically used for hedging purposes or to speculate on downside price action.

Investors often use put options in a risk-management strategy known as a protective put. This strategy is used as a form of investment insurance; this strategy is used to ensure that losses in the underlying asset do not exceed a certain amount (namely, the strike price).

In general, the value of a put option decreases as its time to expiration approaches because of the impact of time decay. Time decay accelerates as an option's time to expiration draws closer since there's less time to realize a profit from the trade. When an option loses its time value, the intrinsic value is left over. An option's intrinsic value is equivalent to the difference between the strike price and the underlying stock price. If an option has intrinsic value, it is referred to as in the money (ITM).

Out of the money (OTM) and at the money (ATM) put options have no intrinsic value because there is no benefit in exercising the option. Investors have the option of short selling the stock at the current higher market price, rather than exercising an out of the money put option at an undesirable strike price. However, outside of a bear market, short selling is typically riskier than buying options.

Time value, or extrinsic value, is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires. Different put options on the same underlying asset may be combined to form put spreads.

There are several factors to keep in mind when it comes to selling put options. It's important to understand an option contract's value and profitability when considering a trade, or else you risk the stock falling past the point of profitability.

The payoff of a put option at expiration is depicted in the image below:

Image by Investopedia

Put options, as well as many other types of options, are traded through brokerages. Some brokers have specialized features and benefits for options traders. For those who have an interest in options trading, there are many brokers that specialize in options trading. It's important to identify a broker that is a good match for your investment needs.

Alternatives to Exercising a Put Option

The put option seller, known as the option writer, does not need to hold an option until expiration (and neither does the option buyer). As the underlying stock price moves, the premium of the option will change to reflect the recent underlying price movements. The option buyer can sell their option and, either minimize loss or realize a profit, depending on how the price of the option has changed since they bought it.

Similarly, the option writer can do the same thing. If the underlying's price is above the strike price, they may do nothing. This is because the option may expire at no value, and this allows them to keep the whole premium. But if the underlying's price is approaching or dropping below the strike price–to avoid a big loss–the option writer may simply buy the option back (which gets them out of the position). The profit or loss is the difference between the premium collected and the premium that is paid in order to get out of the position.

Example of a Put Option

Assume an investor owns one put option on the SPDR S&P 500 ETF (SPY)—and assume it is currently trading at $277.00—with a strike price of $260 expiring in one month. For this option, they paid a premium of $0.72, or $72 ($0.72 x 100 shares).

The investor has the right to sell 100 shares of XYZ at a price of $260 until the expiration date in one month, which is usually the third Friday of the month, although it can be weekly.

If shares of SPY fall to $250 and the investor exercises the option, the investor could establish a short sell position in SPY, as if it were initiated from a price of $260 per share. Alternatively, the investor could purchase 100 shares of SPY for $250 in the market and sell the shares to the option's writer for $260 each. Consequently, the investor would make $1,000 (100 x ($260-$250)) on the put option, less the $72 cost they paid for the option. Net profit is $1,000 - $72 = $928, less any commission costs. The maximum loss on the trade is limited to the premium paid, or $72. The maximum profit is attained if SPY falls to $0.

Contrary to a long put option, a short or written put option obligates an investor to take delivery, or purchase shares, of the underlying stock.

Assume an investor is bullish on SPY, which is currently trading at $277, and does not believe it will fall below $260 over the next two months. The investor could collect a premium of $0.72 (x 100 shares) by writing one put option on SPY with a strike price of $260.

The option writer would collect a total of $72 ($0.72 x 100). If SPY stays above the $260 strike price, the investor would keep the premium collected since the options would expire out of the money and be worthless. This is the maximum profit on the trade: $72, or the premium collected.

Conversely, if SPY moves below $260, the investor is on the hook for purchasing 100 shares at $260, even if the stock falls to $250, or $200, or lower. No matter how far the stock falls, the put option writer is liable for purchasing shares at $260, meaning they face a theoretical risk of $260 per share, or $26,000 per contract ($260 x 100 shares) if the underlying stock falls to zero.