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Put Options - Definition
Put Options are stock options that gives its holder the
POWER, but not the obligation, to SELL the underlying stock at a FIXED PRICE by a fixed EXPIRATION DATE.
Put Options - Introduction
Put Options are the least understood of the 2 kinds of stock options. The other being
Call Options that give you the right to buy the
underlying stock for a fixed price. Put Options enable you to sell the underlying stock at a price fixed right now no matter how
low it falls in future. That said, rarely are put options really
used as a tool to sell your stocks but as a tool to capture value as the underlying stock drops and then sell the put options at a profit! Apart from being an incredibly flexible
and risk limited leverage instrument, Put Options are fantastic
hedging instruments for any stock portfolios.
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Put Options allows investors to do something relatively unfamilar to the stock trading world and that is, to profit from a downturn in stocks
without going into margin or shorting anything. Shorting stocks exposes the investor to unlimited upside risk whereas buying put options
incurrs nothing more than the price you paid for the put options! There are no shorting needed! No shorting, No margin, Limited Loss and Unlimited profits
is what sets the buying of Put Options apart from shorting stocks!
How Do Put Options Work?
Put Options are financial contracts between a buyer and a seller. The seller or "writer" of Put Options is giving the Buyer of those Put Options
the right to sell to him stocks at a price fixed and agreed upon in the Put Options contract. The buyer or "holder" of these Put Options can now
hold on to them, hoping that the stocks will drop in price over time, before the Put Options contract expires, and then either sell the
Put Options on to another buyer at a higher price or buy the stocks at the prevailing market price and then
exercise the right vested in the Put Options to sell the stock to the seller at the
higher agreed price, turning a profit.
Clearly, the seller or "writer" of Put Options is expecting the stocks to stay stagnant or to go up so that he/she can make a profit
out of that sale without
having to really buy the stocks from the holder of the Put Options.
The buyer of those Put Options is clearly expecting those same stocks to go down and is willing to pay a small price to speculate on such a move.
This expectation is also captured in the popular investor sentiment indicator known as
Put Call Ratio. Put Call Ratio is the ratio of the amount of
put options traded versus call options traded.
Here's an example of what happens in a Put Options transaction:
Put Options Example:
XYZ company shares are trading at $40 right now. $40 strike price Put Options are trading at $2.00.
John expects XYZ company shares to go down and shorted 100 shares of XYZ company at $40.
Peter expects XYZ company shares to go down too and bought 1 contract of Put Options of XYZ company (representing 100 shares) for $200.
Scenario 1 : XYZ Rallies To $70 During Expiration Of The Put Options
John lost $3000 (($70 - $40) x 100) from the rally.
Peter only lost the $200 he out towards the purchase of the Put Options and nothing more.
Scenario 2 : XYZ Falls To $30 During Expiration Of The Put Options
John made $1000 (($40 - $30) x 100) from the drop.
Peter made $800 ((($40 - $30) x 100) - 200) from the same drop in net profit after deducting the price of the Put Options, which is a 400% profit!
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Put Options - Terminology
Strike Price
The price at which you can sell shares of the company no matter how far it has moved in the future.
Holder
Owners of Put Options. You are the holder of your Put Options.
Writer
Sellers of Put Options. You are a writer when you initiate a position by selling Put Options. This is called
Sell To Open. Learn More About The
Types Of Options Orders.
Exercise
To initiate the right to sell the underlying stock at the strike price.
Expiration date
The date by which you must exercise the right to buy shares of the company or let the Put Options laspe worthless.
In The Money
When the shares of the company is lower than the strike price. Read more about
In The Money Options.
At The Money
When the shares of the company is the same as the strike price. Read more about
At The Money Options.
Out Of The Money
When the shares of the company is higher than the strike price, making the Put Options worthless upon expiration. Read more about
Out Of The Money Options.
Put Options And Time Decay
Put Options contracts come with a price. That price acts as an "insurance premium" to the buyer and a form of compensation to the writer for
taking on the extra risk. The longer the expiration date of the Put Options, the higher this price is due to the extra risk the writer is
facing. This price has come to be known as the "extrinsic value". As extrinsic value of stock options in general is a function of how
long the period of risk the writer is facing governed by the expiration date, it reduces as expiration date approaches. This reduction in
value over time is known as Time Decay and is governed mathematically by the
Option Greek known as Theta.
Holders of Put Options
need to be aware that if the underlying stock fails to move down quickly and hopefully overtaking the price paid on the Put Options, those
Put Options would reduce in price daily due to time decay. Writers of Put Options need to be aware of whether or not the extrinsic value
of the Put Options that you wish to write justifies the additional risk or fulfills your hedging objectives.
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Please note that this is the practise in the United States. Different countries could have different regulations.
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Applications Of Put Options
There are 2 primary investment functions of Put Options; Leveraged Speculation and Hedging.
Leveraged Speculation
Stock options are great leverage tools that not only produce leveraged, unlimited profits but also limited losses. Put Options are
stock option's solution to providing leveraged returns on falling stocks. Put Options allow its holder to benefit from the same
profit as in shorting the underlying stock using only a small amount of the money and without needing margin nor risking unlimited losses.
Hedging
Like stock futures, stock options were initially created as hedging instruments. Today, Put Options continue to be excellent hedging instruments
used by
investment institutions and individuals alike. Put Options can be bought to hedge against a pullback in long stock
portfolios and can be shorted to hedge against a lift in short stock portfolios. Apart from that, Put Options can also be creatively longed or shorted
to hedge against any kind of options strategies.
Put Options produce hedging through
Delta Neutral as well as
Contract Neutral hedging.
Put Options Trading Strategies
There are many options trading strategies involving the use of Put Options. Here are some of them:
Protective Puts
Protecting and sealing in profits in stocks without selling those stocks.
Bear Put Spread
Profits from a moderate drop in the underlying stock by having short Put Options cover the cost of long Put Options.
Calendar Put Spread
Profits when the underlying stock falls moderately or remains stagnant through buying and writing Put Options of different expiration dates.
Naked Put Write
Profit when the underlying stock remains stagnant or rises moderately by shorting Put Options.
See a full List Of Options Strategies.
Put Options can also be combined with stocks to create call options synthetically without closing the Put Options position. It can
also be used to transform stock positions into Put Options or call options synthetically without closing the original stock position.
This is known as Synthetic Positioning.
Pricing Of Put Options
The price of Put Options consists of 2 components. The intrinsic value and the extrinsic value. Intrinsic value is the amount of profits
already built into the Put Options while the extrinsic value is the price you pay just to own the options contract as a compensation to the
seller or writer for the extra risk. When you purchase At The Money options, where the strike price of the Put Options is exact the same as
the prevailing price of the stock, or Out Of The Money Options, where the strike price of the Put Options is higher than the price of the
prevailing price of the stock, the price of the Put Options would consist of only extrinsic value.
Put Options Pricing Example:
XYZ company shares are trading at $50 right now.
$50 strike price Put Options are trading at $2.00.
$51 strike price Put Options are
trading at $2.80.
$49 strike price Put Options are trading at $0.50.
The $50 strike price Put Options consists of $2.00 extrinsic value and no intrinsic value as there are no profits built into them yet. This is
known as At The Money.
The $49 strike price Put Options consists of $0.50 extrinsic value and no intrinsic value as the stock needs to drop below $49 to make a profit.
This is known as Out Of The Money.
The $51 strike price Put Options consists of $1.80 extrinsic value and $1.00 intrinsic value as the options allows the stock to be sold
at $1 higher than the prevailing price. The value of $1 is captured as intrinsic value. This is known as
In The Money.
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As you can see from the above example, the price of Put Options is affected mainly by where it's strike price is in relation to the price of
the underlying stock. This is known as Options Moneyness and is the most important concept to understand in options trading. Read more about How Stock Options Are Priced. Trading Put Options of different strike prices produces very different results on the same move in the
underlying stock. To learn these different considerations,
please read the Long Put Options strategy.
Prices of Put Options of different strike prices and expiration dates are presented as Options Chains. Here is how typical options chains looks
like:
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XYZ Company, $50, Expiration : Dec 2007
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Symbol
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Strike
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Last
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Bid
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Ask
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Volume
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Open Interest
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.xyzhg
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$49
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$0.50
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$0.30
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$0.50
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1000
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50
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.xyzhh
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$50
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$2.00
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$1.80
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$2.00
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3000
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1000
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.xyzhi
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$51
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$2.60
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$2.60
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$2.80
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50
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5
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Symbol : Every Put Options are identified uniquely with their own names or representations.
Strike : The strike price of each individual Put Options.
Last : The last transacted price of that particular Put Options contract.
Bid : The price at which you can sell a particular Put Options contract at.
Ask : The price at which you can buy a particular Put Options contract at.
Volume : The number of transactions that took place for each individual Put Options contract for the day.
Open Interest : The number of open positions floating in the market for each individual Put Options contract.
Learn More About Volume And Open Interest Of Stock Options.
Get free options chains here.
Where Can You Buy Put Options
You can trade Put Options of any optionable stocks online through the internet simply by opening an account with
any online options trading brokers. Put Options are
also trade in Over The Counter (OTC) markets or what is known as pink sheets for stocks that do not have exchange traded options. However,
these markets are not generally accessible to the public. Exchange traded options are stock options that are publicly traded in the exchanges
just like stocks.
Benefits Of Put Options
Able to profit from falling stocks without needing margin.
Can be used to hedge against stock or options trading positions.
Extremely flexible. Can emulate payoff of stocks or put options through synthetic positions.
Disadvantages Of Put Options
Expires worthless if the stock trades above strike price by expiration.
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