A put option is the right to sell a security at a specific price until a certain date. It gives you the option to "put the security down." The right to sell a security is based on a contract. The securities are usually stocks but can also be commodities futures or currencies.
The specific price is called the "strike price," because you will presumably strike when the stock price falls to that value or lower. And, you can only sell it up to an agreed-upon date. That's known as the "expiration date," because that's when your option expires.
In an American option, if you sell your stock at the strike price before the expiration date, you "exercise" your put option. In a European option, you can only exercise your put option exactly on the expiration date.
- A put option can make another investor or trader buy or sell a security before the option expires.
- A put option always comes with a strike price that you set to keep you from losing more than you can afford.
- You can buy and sell put options based on your trading strategy and your anticipation of the asset's price.
When you buy a put option, that guarantees you'll never lose more than the strike price. You pay a small fee to the person who is willing to buy your stock.
The fee covers their risk. After all, they realize you could ask them to buy it any day during the agreed-upon period. They also realize there's the possibility the stock could be worth much less on that day. But they think it's worth it because they believe the stock price will rise. Like an insurance company, they'd rather have the fee you give him in return for the slight chance they'll have to buy the stock.
- Long Put: If you buy a put without owning the stock, this is known as a long put.
- Protected Put: If you buy a put on a stock you already own, that's known as a protected put. You can also buy a put for a portfolio of stocks or an exchange-traded fund (ETF). That's known as a "protective index put."
When you sell a put option, you agree to buy a stock at an agreed-upon price. It's also known as shorting a put.
Put sellers lose money if the stock price falls. That's because they must buy the stock at the strike price but can only sell it at a lower price.
They make money if the stock price rises because the buyer won't exercise the option. The put sellers pocket the fee.
Put sellers stay in business by writing lots of puts on stocks they think will rise in value. They hope the fees they collect will offset the occasional loss they incur when stock prices fall.
A put seller's mindset is similar to an apartment owner. They hope they'll get enough rent from the responsible tenants to offset the cost of the deadbeats and those who wreck the apartment.
A put seller can get out of the agreement anytime by buying the same option from someone else. If the fee for the new option is lower than what he received for the old one, they pocket the difference. They would only do this if they thought the trade was going against them.
Some traders sell puts on stocks they'd like to own because they think they are currently undervalued. They are happy to buy the stock at the current price because they believe it will rise again in the future. Since the buyer of the put pays them the fee, they buy the stock at a discount.
- Cash Secured Put Sale: You keep enough money in your account to buy the stock or cover the put.
- Naked Put: This is when you sell a put unhedged. This option strategy is not covered by cash but rather by margin.
Example Using Commodities
Put options are used for commodities as well as stocks. Commodities are tangible things like gold, oil, and agricultural products, including wheat, corn, and pork bellies. Unlike stocks, commodities aren't bought and sold outright. No investor or trader purchases and takes ownership of a "pork belly."
Instead, commodities are bought as futures contracts. These contracts are hazardous because they can expose you to unlimited losses. Why? Unlike stocks, you can't buy just one ounce of gold. A single gold contract is worth 100 ounces of gold. If gold loses $1 an ounce the day after you bought your contract, you've just lost $100. Since the contract is in the future, you could lose hundreds or thousands of dollars by the time the contract comes due.
Put options are used in commodities trading because they are a lower-risk way to get involved in these risky commodities futures contracts. In commodities, a put option gives you the option to sell a futures contract on the underlying commodity. When you buy a put option, your risk is limited to the price you pay for the put option (premium) plus any commissions and fees.
Even with the reduced risk, most traders don't exercise the put option. Instead, they close it before it expires. They use it for insurance to protect against loss.
Frequently Asked Questions (FAQs)
What happens when a put option expires?
If a put option expires before it is exercised, it essentially disappears. The brokerage will remove that option from the account of the person who bought the put. The person who sold the put no longer has to worry about maintaining the buying power to purchase the shares. Keep in mind that brokerages may automatically exercise options on the expiration date if they are in the money (ITM), so ITM options are unlikely to expire.
What happens when you exercise a put option?
When you exercise a put option, you sell 100 shares at the option's strike price. You must own those shares to sell them. If you don't own them before exercising the option, then you'll need the buying power to cover that purchase—even though you may only own the shares for a matter of minutes.
How do you close a put option?
If you sold the put to open the trade, then you will buy the put at the current market price to close it. If you originally bought the put option, then you will sell it to close the trade. An option's expiration or exercise will also close the trade for both parties involved.
When should you buy a put option?
In general, you want to buy a put option when you have a bearish sentiment about a security. In other words, buy puts when you feel like the stock's price will go down. Some traders use puts to hedge other positions they hold. For example, if someone owns a lot of Apple, they may want to buy an Apple put so they don't lose everything if Apple crashes.