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Put options are the lesser-known cousin of call options, but they can be every bit as profitable and exciting as their more popular relative. Puts and calls are the two basic types of vehicles used in strategies surrounding options trading.
This article provides an overview of why investors buy and sell put options on a stock, and how doing so compares to short-selling the stock directly.
What is a put option?
Options are a type of financial instrument known as a derivative because their value is derived from another security, or underlying asset. Here we discuss stock options, where the underlying asset is a stock.
A put option is a contract that gives the owner the option, but not the requirement, to sell a specific underlying stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”).
For this option to sell the stock, the put buyer pays a "premium" per share to the put seller.
Each contract represents 100 shares of the underlying stock. Investors don’t have to own the underlying stock to buy or sell a put.
If you think the market price of the underlying stock will fall, you can consider buying a put option compared to selling a stock short. If you think the market price of the underlying stock will stay flat or move up, you can consider selling or "writing" a put option.
For a put buyer, if the market price of the underlying stock moves in your favor, you can elect to "exercise" the put option or sell the underlying stock at the strike price. American-style options allow the put holder to exercise the option at any point up to the expiration date. European-style options can be exercised only on the date of expiration.
Buying and selling put options can be used as part of more complex option strategies.
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Buying a put option
Put options can function like a kind of insurance for the buyer. A stockholder can purchase a "protective" put on an underlying stock to help hedge or offset the risk of the stock price falling because the put gains from a decline in stock prices. But investors don't have to own the underlying stock to buy a put. Some investors buy puts to place a bet that a certain stock's price will decline because put options provide higher potential profit than shorting the stock outright.
If the stock declines below the strike price, the put option is considered to be “in the money.” An in-the-money put option has "intrinsic value" because the market price of the stock is lower than the strike price. The buyer has two choices: First, if the buyer owns the stock, the put option contract can be exercised, putting the stock to the put seller at the strike price. This illustrates the "protective" put because even if the stock's market price falls, the put buyer can still sell the shares at the higher strike price instead of the lower market price. Second, the buyer can sell the put before expiration in order to capture the value, without having to sell any underlying stock.
If the stock stays at the strike price or above it, the put is “out of the money” and the option expires worthless. Then the put seller keeps the premium paid for the put while the put buyer loses the entire investment.
Here’s an example. XYZ is trading for $50 a share. Puts with a strike price of $50 are available for a $5 premium and expire in six months. In total, one put contract costs $500 ($5 premium x 100 shares).
The graph below shows the put buyer's profit or payoff on the put with the stock at different prices.
Because one contract represents 100 shares, for every $1 decrease in the stock's market price below the strike price, the total value of the option increases by $100.
The breakeven point — below which the option begins to earn a profit, have intrinsic value or be in the money — occurs at $45. That is the strike price of $50 minus the $5 cost of the put. If the stock trades between $45 and $50, the option will retain some value, but does not show a net profit. Conversely, if the stock remains above the strike price of $50, the option is out of the money and becomes worthless. So the option value flatlines, capping the investor’s maximum loss at the price paid for the put, of $5 premium per share or $500 total.
Buying a put option vs. short selling
Buying put options can be attractive if you think a stock is poised to decline, and it’s one of two main ways to wager against a stock. The other is short selling. To “short” a stock, investors borrow the stock from their broker and sell it in the market to lock in the current market price with the intention of buying it back if and when the stock price declines. The difference between the sell and buy prices is the profit. Puts can pay out more than shorting a stock, and that’s the attraction for put buyers.
Here’s an example to compare the two strategies. XYZ stock is trading at $50 per share, and for a $5 premium, an investor can purchase a put option with a $50 strike price expiring in six months. Each options contract represents 100 shares, so 1 put contract costs $500. The investor has $500 in cash, allowing either the purchase of one put contract or shorting 10 shares of the $50 XYZ stock.
Here’s the payoff profile at expiration for short-sellers, put buyers and put sellers.
There's a reason why put buyers get excited. If the stock moves down 40%, a short-seller earns $200 (sold 10 shares at a $50 market price to earn $500 and bought 10 shares back at $30 paying out $300, $500 - $300 = $200 in total profit). However, owning a put option magnifies that downward move and earns a $1,500 gain for the put owner ($50 strike price - $30 market price = $20 gain per share. $20 - $5 cost of the contract = $15 gain per share x 100 shares = $1,500 in profit) . Buying puts offers better profit potential than short selling if the stock declines substantially. The put buyer's entire investment can be lost if the stock doesn’t decline below the strike by expiration, but the loss is capped at the initial investment. In this example, the put buyer never loses more than $500.
In contrast, short selling offers less profitability if the stock declines, but the trade becomes profitable as soon as the stock moves lower. At $45, the trade has already made a profit, while the put buyer has just broken even. The biggest advantage for short-sellers, though, is that they have a longer time horizon for the stock to decline. While options eventually expire, a short-seller need not close out a short-sold position, as long as the brokerage account has enough capital to maintain it.
The most significant downside to short selling is that losses can be theoretically infinite if the stock continues to climb. While no stocks have soared to infinity yet, short-sellers could lose more money than they put into their initial position. If the stock price continued to rise, the short-seller might have to put up additional capital in order to maintain the position.
Selling a put option
Put sellers (writers) have an obligation to buy the underlying stock at the strike price. The put seller must have either enough cash in their account or margin capacity to buy the stock from the put buyer. However, a put option typically will not be exercised unless the stock price is below the strike price; that is, unless the option is in the money. Put sellers generally expect the underlying stock to remain flat or move higher. Put sellers make a bullish bet on the underlying stock and/or want to generate income.
If the stock declines below the strike price before expiration, the option is in the money. The seller will be put the stock and must buy it at the strike price.
If the stock stays at the strike price or above it, the put is out of the money, so the put seller pockets the premium. The seller can write another put on the stock, if the seller wants to try to earn more income.
Here’s an example. XYZ is trading for $50 a share. Puts with a strike price of $50 can be sold for a $5 premium and expire in six months. In total, one put contract sells for $500 ($5 premium x 100 shares).
The graph below shows the seller's profit or payoff on the put when the stock is at various prices.
Each contract represents 100 shares, so every $1 decrease in the stock below the strike price, the option's cost to the seller increases by $100. The breakeven point occurs at $45 per share, or the strike price minus the premium received. The put seller’s maximum profit is capped at $5 premium per share, or $500 total. If the stock remains above $50 per share, the put seller keeps the entire premium. The put option continues to cost the put seller money as the stock declines in value.
In contrast to put buyers, put sellers have limited upside and significant downside. The maximum that the put seller can receive is the premium — $500 — but the put seller must buy 100 shares of stock at the strike price if the buyer exercises the put option. Potential losses could exceed any initial investment and could amount to as much as the entire value of the stock, if the underlying stock price went to $0. In this example, the put seller could lose as much as $5,000 ($50 strike price paid x 100 shares) if the underlying stock went to $0 (as seen in the graph).
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More put option strategies
Put options remain popular because they offer more choices in how to invest and make money. One lure for put buyers is to hedge or offset the risk of an underlying stock's price falling. Other reasons to use put options include:
Limit risk-taking while generating a capital gain. Put options can be used to limit risk For example, an investor looking to profit from the decline of XYZ stock could buy just one put contract and limit total downside to $500, whereas a short-seller faces unlimited downside if the stock moves higher. Both strategies have a similar payoff, but the put position limits potential losses.
Generate income from the premium. Investors can sell options to generate income, and this can be a reasonable strategy in moderation. Especially in a rising market, where the stock is not likely to be put to the seller, selling puts can be attractive to produce incremental returns.
Realize more attractive buy prices. Investors use put options to achieve better buy prices on their stocks. They can sell puts on a stock that they’d like to own but that is too expensive currently. If the price falls below the put’s strike, then they can buy the stock and take the premium as a discount on their purchase. If the stock remains above the strike, they can keep the premium and try the strategy again.