Put options are a type of option that increases in value as a stock falls. A put allows the owner to lock in a predetermined price to sell a specific stock, while put sellers agree to buy the stock at that price. The appeal of puts is that they can appreciate quickly on a small move in the stock price, and that feature makes them a favorite for traders who are looking to make big gains quickly.
- Put Options: What Are They and How to Buy Them
A put option allows investors to bet against the future of a company or index. More specifically, it gives the owner of an option contract the ability to sell at a specified price any time before a certain date.
Put options are a great way to hedge against market declines, but they, like all investments, come with a bit of risk. For starters, you can lose not only what you invested, but also any chance for profits. That’s what happened to many investors during the short-squeeze mania surrounding shares of Gamestop in early 2021. The same applied to shares of AMC from late May into early June of 2021. Those who bought put options on these stocks before they went up saw their options fall significantly in value as such stocks rose in value.
Let’s break down how put options work and how to buy them in 2022.
Table of content
- what is Put Option Trading?
- How the Put Option Trading Work?
- Put Option Trading Strategies
- How To But Put Option?
- Buying Uncovered Put Options
What Is a Put Option?
- Buying a put option gives you the right to sell a stock at a certain price (known as the strike price) any time before a certain date. This means you can require whomever sold you the put option (known as the writer) to pay you the strike price for the stock at any point before the time expires. However, you are under no obligation to do so.
- Buying put options is a way to hedge against a potential drop in share price. They could also reap profits from bear markets or declines in the prices of individual stocks.
- You should also understand the risks associated with put option investing, though. Because options are derivatives, they receive their value through an underlying security. This reliance on other securities makes options generally more complicated and risky than investors who focus on individual securities, like stocks and bonds.
- Depending on the type of derivative, your losses could be much more than the amount you’ve invested. In the worst-case scenario, losses for some derivatives can be nearly limitless, so tread lightly.
How does a put option work?
- Put options are in the money when the stock price is below the strike price at expiration. The put owner may exercise the option, selling the stock at the strike price. Or the owner can sell the put option to another buyer prior to expiration at fair market value.
- A put owner profits when the premium paid is lower than the difference between the strike price and stock price at option expiration. Imagine a trader purchased 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 has made a profit of $4.20.
- If the stock price is above the strike price at expiration, the put is out of the money and expires worthless. The put seller keeps any premium received for the option.
4 Types of Put Option Strategies
There are several common trading strategies when it comes to put options:
- 1. Long put: This is the most common put option strategy and involves the investor taking on the role of the option contract holder (aka the buyer). In a long put, the investor bets that the underlying stock or asset price will decrease.
- 2. Short put: In a short put also called a naked put the investor takes on the role of the option contract writer (aka the seller). In a short put, the investor bets that the underlying stock or asset price will increase. Investors who use this strategy aim to profit off the option premium fee that the buyer pays them at the contract’s start. Short puts can be risky since the investor is potentially obligated to buy worthless shares in the underlying asset if the market price of the shares plummets drastically.
- 3. Protective put: Protective put options are essentially an insurance strategy investors can use when taking a long position on a regular stock market trade. For example, if an investor purchases stock shares, they're hoping the stock price increases, but they could also buy a protective put so that if the stock price decreases below the put option's strike price, they still profit on the put option. If the stock price increases above the strike price, they profit off the stock trade and only lose the cost of their option premium on the protective put.
- 4. Bear put spread: Also known as a debit put spread, this is a strategy for options investors who want to decrease the cost of holding an options contract using a short put option to fund a long put option. In a bear put spread, the investor simultaneously buys and sells a put option contract with the same expiration date on the same underlying asset but with different strike prices. This strategy reduces the trade risk and limits profits to the difference between strike prices.
How to Buy Put Options
- To buy put options, you have to open an account with an options broker. The broker will then assign you a trading level. That limits the type of trade you can make based on your experience, financial resources and risk tolerance.
- To buy a put option, first choose the strike price. This will normally be somewhat below where the stock is currently trading.
- Next choose an expiration date. This could typically be from a month to a year in the future. Longer time periods generally mean less risk.
- Next decide how many contracts to buy. Each options contract is for 100 shares of stock. For each contract you will pay the listed premium for that option, plus brokerage fees.
- After paying, watch stock prices to see if it’s time to exercise the option. You can exercise the option at any time before the expiration date.
- If current prices fall below the strike price, the option is considered in the money. If your option is on the money, you can require the writer of the option to purchase your shares at the higher strike price.
- Should the stock price not decline, you can let the option expire. You won’t make anything but your losses will be limited to the option costs and fees.
Buying Uncovered Put Options
- You can also buy put options for shares you don’t own. But you have to buy the shares before exercising the that uncovered put option. You can buy put options on indexes as well as individual securities. This can produce profits from broad declines in bear markets.
- If the price of the optioned shares in the earlier example fell to $90, the buyer of an uncovered put option could still require the writer to purchase 100 shares for $100 each. First, he or she would purchase the shares for $90 each. After paying the $200 option premium, this put option would earn $800.
- Of course, the share prices might not decline below the strike price. Then the put option buyer would let the option expire unused. The $200 would have been spent for no gain.
- Buying uncovered put options gives an investor lots of leverage. In this example, the investor controls shares worth $10,000 at a cost of only $200. That $200 is also all the investor has at risk.
- However, the profit potential in this example is as high as $10,000, or $9,800 after the $200 option premium, should the shares drop to zero in value.