When Is a Put Option Bullish or Bearish?
Demystify put options: learn how buying or selling them reveals an investor's true market outlook.
Options trading involves financial contracts that derive their value from an underlying asset, like a stock. These instruments provide opportunities for investors to participate in market movements without directly owning the asset. Understanding the direction of the market, whether it is expected to rise or fall, is a fundamental aspect of finance. This market sentiment plays a significant role in how various financial tools, including options, are utilized by investors to align with their outlook.
Understanding Put Options
A put option is a financial contract that grants the holder the right, but not the obligation, to sell an underlying asset at a specified price, known as the “strike price,” on or before a particular “expiration date.” The asset might be a stock, an exchange-traded fund, or another security. The cost to purchase this right is called the “premium,” which is paid by the buyer to the seller of the option.
Each put option contract typically represents 100 shares of the underlying asset. The value of a put option is intrinsically linked to the price of the underlying asset, meaning its value is derived from that asset’s price movements. Options are considered derivatives because their worth is contingent upon another security.
Defining Bullish and Bearish Markets
In financial markets, the terms “bullish” and “bearish” describe prevailing sentiment or expectations about price movements. A “bullish” market or sentiment indicates an expectation that prices, whether for individual securities or the market as a whole, are likely to increase.
Conversely, a “bearish” market or sentiment reflects an expectation that prices will decline. A common measure for a bear market is a price decline of 20% or more from a recent peak.
Why Buying Puts is Bearish
When an investor buys a put option, it is a bearish action. This means the investor anticipates that the price of the underlying asset will fall below the strike price before the option’s expiration date. The primary motivation for purchasing a put is to profit from a decline in the asset’s value.
The value of a purchased put option increases as the underlying asset’s price decreases. Buying puts can serve as a form of speculation or as a hedging strategy to protect an existing portfolio against potential losses. The maximum loss for a put buyer is limited to the premium paid, making it a defined-risk strategy compared to short selling. Profits from buying and selling options are classified as capital gains for tax purposes.
How Selling Puts Can Signal Bullishness
Selling a put option indicates a neutral-to-bullish outlook on the underlying asset. When an investor sells a put, they receive a premium upfront from the buyer. In exchange, the seller incurs an obligation to buy the underlying asset at the strike price if the option is exercised by the buyer.
An investor sells a put when they expect the underlying asset’s price to remain above the strike price or to increase. If the price stays above the strike until expiration, the put option expires worthless, and the seller retains the entire premium as profit. Should the price fall below the strike, the seller is obligated to purchase the shares at the agreed-upon strike price.
This willingness to acquire the stock at the strike price, even if it’s currently trading lower, suggests that the seller views that price as an acceptable entry point for ownership, implying a long-term positive belief in the stock. For tax purposes, the premium received from selling a put is treated as income when collected.