What is a Put Option?
A put option is a financial contract that gives the option buyer the right, but not the obligation, to sell an asset at a pre-determined price within a pre-determined time frame. These are called “put” options because they represent the right to put the asset up for sale.
Put options are financial derivatives because their value is based on and derived from an asset called the underlying asset. This asset can come in many forms. It can be shares of financial stock of companies, bonds, commodities, etc.
The opposite of a put option would be a call option.
How does a put option work?
A put option based on stock allows the owner of the option the right to sell 100 shares of that stock at a certain price before or on a certain date. The pre-determined price is called the strike price while the date is called the expiration date.
Generally speaking, a put option will rise in value when the underlying stock falls in price. However, a put option will not always increase in value if the underlying stock falls because this is too simplistic. A put option will also decrease in value as you approach the expiration date. Additionally, if there is external information that indicates an important event is coming up that might cause the underlying stock to fall in price, the value of the put option will also rise in anticipation. All of these factors combine to determine the value of a put option.
One important point to keep in mind is that the prices of options you see in all quotes are always shown per share of stock. Since each option represents 100 shares, the actual price will be the price you see times 100. For example, a put option might be shown in a quote to cost $0.75. If you were to buy this option, it would cost $75. Most brokerage firms will usually show you a confirmation prompt after you enter an order asking you to confirm before submitting the order. This confirmation prompt should automatically show you the actual price.
What is the maximum I can gain or lose?
Unlike with call options, neither the max gain nor the max loss can be theoretically unlimited.
If you are long a put option, meaning you buy a put option to open a position, the max you can gain is a defined number that will show up if the stock price falls to zero while the max you can lose is just the initial price you paid for the put option. The max possible gain is calculated by simply taking the strike price of the put option and subtracting the amount initially paid to buy the put option. This is because if the stock were to fall to zero, you could theoretically buy shares of the stock at $0 and then sell them by exercising your put option to sell at the strike price. Also keep in mind that each option represents 100 shares. Therefore, the max potential profit for a put option would taking the strike price, minus zero, multiply by 100, and finally minus the price you paid to buy the put option in the first place.
Max Profit = (Strike Price – 0) * 100 – initial premium
Max Loss = Initial price you paid to buy the put option
Check out the below chart that illustrates the outcomes of a put option that is bought at the example price of $100.
If you are short a put option, meaning you sell a put option to open a position, the situation is reversed. The max you can gain is just the initial price you received when you sold the put option and the max you can lose is a defined number that will show up if the stock price falls to zero. This number is calculated by taking the strike price, multiplying by 100 (because each option represents 100 shares), and then subtracting the value you collected when you sold the put option in the first place.
Max Profit = Initial price you received when you sold the put option
Max Loss = (Strike Price – 0) * 100 – initial premium
Check out the below chart that illustrates the outcomes of a put option that is sold at the example price of $100.
What are the parts of a put option’s price?
The price of a put option is called the premium and is made up of two parts, the extrinsic value and the intrinsic value.
Option Price = Extrinsic Value + Intrinsic Value
The extrinsic value is the value that is solely from the option itself and external from the underlying stock. It is always a positive non-zero number. The easiest way to calculate this is to simply subtract the intrinsic value, if any, from the option price.
Extrinsic Value = Option Value – Intrinsic Value
This then leads to the question, how do we calculate the intrinsic value? The intrinsic value represents the value, if any, that would be produced if you were to immediately exercise the option. For put options, the intrinsic value can be calculated by simply taking the strike price and subtracting the current price of the underlying stock.
Intrinsic Value = Strike Price – Current Price of Stock
The intrinsic value is always either a positive non-zero number or zero. You either have some intrinsic value or you have none. If the current price of the stock is above the strike price, a put option has no intrinsic value and the entirety of the option value is extrinsic.
How do you activate your put option to sell shares?
In order to activate your put option to sell shares, you would have to exercise your put option contract. The method to exercising your option depends on your brokerage firm. Some will require you to contact customer support while some may have a streamlined process that can be done entirely online through their interface. Keep in mind that in order to sell the 100 shares that a put option represents, you will need to possess the shares of stock to sell.
If you end up exercising your put option without having the shares in your account, the brokerage firm will often loan you the shares of stock in the form of margin. Keep in mind that these will be borrowed shares, which not only will have interest fees, but is something you will eventually have to return back to the brokerage.
For example, if you own 100 shares of Apple stock and possess a put option with a strike price of $1000, exercising the put option will allow you to sell your 100 shares of Apple stock at $1000 per share resulting in $100,000 in cash.
Why would someone buy a put option?
If you are bearish on a stock, buying a put option is often cheaper and easier than directly shorting stock. Some investors may not even have the ability to short stock in their accounts so buying a put may be their only way to take advantage of a bearish view.
Due to the structure of how options are priced and that they represent 100 shares of stock, they can provide significant exposure and leverage. Coupled with the fact that they can be bought for relatively low prices, some traders may find them useful in speculating on the movement of stock.
Traders also take advantage of the pre-determined maximum loss on long put options (the initial price you paid to buy the put options) to precisely define and control their risk.
A popular method of utilizing put options is to provide hedging against downturns in the market. If the market is in a downtrend, some investors may buy put options, which might profit if the market continues falling. These profits would help offset losses that the rest of the portfolio might incur as the market falls.
Lastly, put options may be combined with other call or put options to create different profit and loss scenarios that may better fit different goals or strategies.
How can a put option be used if you are bullish?
Put options are also often used by those with bullish views. Instead of buying a put option to open a position, these traders would sell a put option to open a position. If the underlying stock continues to rise, the put option will generally fall in value and these traders would subsequently be able to buy back their put option at a lower price to close out of their position with a profit.
Alternatively, even if the price of the underlying stock does not move and generally stays at the same level, the put option will generally also fall in value due to time decay since options typically lose value as the expiration date approaches.
Keep in mind that selling a put option can come with a very large, albeit defined, maximum loss scenario. As a result, many brokerage firms will not allow most customers to sell put options without an appropriate amount of collateral, whether that be cash or shares of stock.
One way to mitigate and reduce the maximum loss scenario is to open a credit put spread as opposed to solely selling a put option. This involves selling a put option but then also buying another put option at a lower strike price. By doing so, one can greatly reduce the maximum loss potential which brokerage firms recognize and consequently are more lenient towards.