What Is a Put Option: Long, Short, Buy, Sell, Example
The Long and Short of Put Options
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 the security is 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.
If you sell your stock at the strike price before the expiration date, you are exercising your put option. Unless you're in Europe. In that case, you can only exercise your put option exactly on the expiration date.
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 his risk. After all, he realizes you could ask him to buy it on any day during the agreed-upon period. He also realizes there's the possibility the stock could be worth far, far less on that day. However, he thinks it's worth it because he believes the stock price will rise. Like an insurance company, he'd rather have the fee you give him in return for the slight chance he'll have to buy the stock.
Long Put: If you buy a put without owning the stock, that's 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 for an exchange traded fund (ETF). That's known as a protective index put.
When you sell a put option, you agree to buy 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 the lower price.
They make money if the stock price rises. That's 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.
Their mindset is similar to an apartment owner. He hopes that he'll get enough rent from the responsible tenants to offset the cost of the deadbeats and those who wreck his apartment.
A put seller can get out of the agreement any time 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, he pockets the difference. He would only do this if he thought the trade was going against him.
Some traders sell puts on stocks they'd like to own, and they think 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 actually buy the stock at a discount. (Source: "The Lure of Cash-Secured Puts," Barron's, September 7, 2015.)
Cash Secured Put Sale: You keep enough money in your account to buy the stock, or cover the put.
Naked Put: You don't keep enough in the account to buy the stock.
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 one 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 highly 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 just use it for insurance to protect their losses.
Hedge funds use put options to make money in a bear market or stock market crash. Hedge fund Jabre Capital Partners SA bought put options on the German stock index fund, the FTSE 25. The company thought that German stocks would decline thanks to the Greece debt crisis in 2011. Corriente Advisors LLC bought put options against the Chinese yuan. The firm believed the currency's value would fall. (Source: "Tudor Leads Hedge Funds Using Options to Bet on China Stocks," Bloomberg, May 26, 2011.)
To make it a little more clear, here's a real life example. Joshua Kennon wanted to buy stock in Tiffany & Co because his research showed the company was profitable. He got his chance when the market plummeted during the 2008 financial crisis. Tiffany's stock prices fell from $57 to $29 a share.
Rather than buy, say, $30,000 for 1,000 shares of Tiffany's, he sold put options. Panicked Tiffany stockholders agreed to pay him around $5 a share for the option of selling Tiffany stock to him for $20 a share. He received $5,000 from the stockholders and set it aside. He also set aside $15,000 in case the options were exercised.
In total, he now had $20,000 earning interest so he could buy the 1,000 shares of Tiffany's. Worst case, he bought 1,000 shares of a profitable company at a good price. If the stock market improved, he still got to keep the $5,000. To read the entire story, see Getting Paid to Invest in Stocks by Trading Sell to Open Put Options.