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, 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 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 were 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: 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 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.