What Are Puts: How They Work and How to Trade Them

Options are financial contracts that derive their value from an underlying asset, such as a stock or an index. They provide the holder with the right, but not the obligation, to engage in a transaction involving that asset. Put options represent a distinct category designed for specific investment objectives.

Defining Put Options

A put option is a contract that grants the buyer the right, but not the obligation, to sell an underlying asset at a specified price on or before a particular date. This right to sell distinguishes puts from other option types. Each standard equity option contract typically represents 100 shares of the underlying stock.

The price at which the underlying asset can be sold is known as the “strike price.” This predetermined price is a core component of the option contract. The “expiration date” is another crucial element, marking the final day the option holder can exercise their right to sell the asset. For this right, the buyer pays a fee to the seller, referred to as the “premium,” which is the upfront cost of the option contract.

Consider an investor buying a put option on XYZ stock, currently trading at $100 per share. They purchase a put with a strike price of $95 and an expiration date three months in the future, paying a premium of $3 per share. Since each contract covers 100 shares, the total cost for one contract would be $300. This contract gives the investor the right to sell 100 shares of XYZ stock at $95 per share anytime before or on the expiration date.

If XYZ stock’s price falls to $90 before expiration, the put option becomes valuable. The investor can exercise their right to sell 100 shares at $95, even though the market price is $90. Exercising would allow them to sell the shares for $9,500 and immediately buy them back in the market for $9,000, realizing a gross profit of $500. After deducting the $300 premium paid, the net profit would be $200. The buyer’s maximum potential loss is limited to the premium paid, which is $300 in this scenario, if the stock price does not fall below the strike price.

From the seller’s perspective, they receive the $300 premium upfront for writing (selling) the put option. If the stock price stays above $95, the option will expire worthless, and the seller keeps the entire premium as profit. However, if the stock price falls below $95 and the buyer exercises the option, the seller is obligated to buy 100 shares of XYZ stock at the $95 strike price, regardless of how low the market price drops. The seller’s profit is capped at the premium received, but their potential loss can be substantial if the stock price declines significantly.

Applications of Put Options

Put options serve various purposes for investors, ranging from speculating on market declines to protecting existing portfolios and generating income.

Speculation

One common use of put options is for speculation. Investors who anticipate a decline in an underlying asset’s price can buy put options to profit from this downward movement. This strategy allows them to gain exposure to a bearish outlook without short-selling the actual stock, which can have unlimited risk. For instance, if an investor believes ABC Company’s stock, currently at $50, will drop due to an upcoming earnings report, they might buy put options with a strike price of $45. If the stock indeed falls to $40, the put options would increase in value, providing a profit for the investor.

Hedging

Put options are also widely used for hedging, acting as a form of insurance to protect an existing long position in a stock or portfolio against potential price declines. An investor owning 200 shares of XYZ stock, purchased at $70 per share, might buy two put option contracts with a strike price of $65 to safeguard against a market downturn. If XYZ stock drops to $60, the loss on their stock holdings would be offset by the gain in the value of their put options, limiting their overall downside risk. This protective strategy ensures that even if the market falls, the investor has the right to sell their shares at the predetermined strike price.

Income Generation

Furthermore, selling (writing) put options can be a strategy for income generation. Investors who are willing to purchase a stock at a lower price can sell put options to collect the premium. This approach is typically favored by those who are bullish or neutral on the stock and would not mind owning it if the price falls to the strike price. For example, an investor might sell a put option on DEF stock with a $30 strike price, receiving a premium of $1.50 per share. If DEF stock remains above $30 until expiration, the option expires worthless, and the investor keeps the $150 premium as income. However, if DEF stock falls below $30, the seller might be obligated to buy the shares at $30, potentially at a price higher than the current market value.

Trading Put Options

Trading put options requires an understanding of the practical steps involved, from opening an account to managing positions and knowing potential outcomes at expiration. Accessing options trading typically involves opening a brokerage account and obtaining specific approval levels from the broker. This approval process often requires investors to demonstrate an understanding of the risks associated with options and their financial suitability for such trading.

Once approved, an investor can place an order to buy a put option, often referred to as a “buy to open” transaction. If an investor already holds a put option and wishes to sell it before expiration, they would place a “sell to close” order. Conversely, when an investor sells a put option to generate income, this is a “sell to open” transaction. To exit this position, they would typically place a “buy to close” order, repurchasing the option they initially sold.

Moneyness of Put Options

The “moneyness” of a put option describes its relationship between the strike price and the current market price of the underlying asset:
In-the-money (ITM): The underlying asset’s price is below the strike price, meaning it has intrinsic value. For instance, a put with a $50 strike price is ITM if the stock is trading at $48.
At-the-money (ATM): The strike price is equal or very close to the current market price.
Out-of-the-money (OTM): The underlying asset’s price is above the strike price, and it has no intrinsic value. For example, a put with a $50 strike price is OTM if the stock is trading at $52.

Expiration Outcomes

At expiration, there are several possible outcomes for a put option. If the underlying asset’s price is below the strike price (ITM), the put buyer can choose to “exercise” their right to sell the asset at the strike price. This action is typically executed through their brokerage, which facilitates the sale of the underlying shares at the specified strike price. However, most put options are not exercised; instead, buyers often sell their options before expiration to lock in profits or minimize losses.

If the underlying asset’s price is above the strike price (OTM) at expiration, the put option will expire worthless. In this scenario, the buyer loses the entire premium paid. For those who sold (wrote) put options, if the option is ITM at expiration and the buyer chooses to exercise, the seller will be “assigned” and obligated to buy the underlying asset at the strike price. This obligation means the seller must purchase the shares at the predetermined price, even if the market price is lower. Tax implications for options profits and losses are generally treated as capital gains.