We’ve already explained how options contracts work, but there’s much more to them. One way to trade options is to buy a put option, which is a contract that gives the holder the right to sell 100 shares of an underlying security, for a specified strike price, by an expiry date. In return, the buyer pays a premium to the seller.
Puts make sense to buy if you think the stock in question is going to decrease in value: if it does, you could, in theory, purchase it at its new, low price – and sell it at its (higher) strike price. Bad news for the stock itself, but great news for you. On the other hand, if the deadline arrives and the stock fails to drop below the strike price, well, tough luck: you’ve paid a premium, but your bet hasn’t worked out.
The buyers of a put option have what’s referred to as a “bearish” outlook on the underlying stock: they’re doubtful of its value, and expect the market will realize this, too, causing its price to drop in the future. With a put option, they’re making a bet this will indeed happen. Say they’re right, and the stock does indeed drop. If it falls enough that it’s now below the value our trader set as their option’s strike price, that option is then said to be “in the money,” since the option holder could buy the stocks from the market, sell them to the option seller at the strike price, and end up with more money than they started with. And if that gain happens to be more than the premium they paid for the option in the first place, they’d make a profit from the deal.
This, however, isn’t the only way to make a profit off of holding a put option. Like the stock that it’s based on, the put option itself can also be traded. Say you own one on a stock that hasn’t yet dropped in value enough to make exercising the option profitable – that isn’t yet ‘in the money.’ That option itself is still valuable, say, to another trader who still thinks it might get there. If the underlying stock has a sharp price decrease, and there’s still plenty of time left before your option expires, other traders may be willing to buy it from you on the expectation that it will still fall further. The closer a put option gets to being in the money, the more valuable it becomes – so long as there is time remaining. As time passes, the chance of the option turning a profit for the option holder (and a liability for the seller) diminishes. Accordingly, the value of put options decrease over time.
A put option as insurance
Not all puts are bought with bearish desire. Say you already own 100 shares of a particular stock, and you’re worried that it might be headed for a downturn in the future. That would be bad news for your investment, but you can find a better price by purchasing a put option on that very same stock. If the stock does indeed decline in value, you’ll still be able to sell at the strike price of your put. You’ll still be taking a loss, but a lesser one than if you’d just sold at the new market price.
This strategy is referred to as a “married put,” and it’s a popular hedging strategy. It’s like buying insurance for a house or a car: you don’t want your house to catch on fire, but if it does, thankfully you have insurance to cover the losses. Investors will pay a small premium to buy the put option, which gives them some assurance that, in the event the underlying value falls rapidly, they’ll be able to use their option right to sell their 100 shares at a higher price. They don’t want the market price to decrease, but if it does, they are protected.
The perspective of the seller
Like with any trade, there’s someone on the other side of the put contract. The seller of a put option is the option writer. They receive the premium when the option trade is made, and in return, agree to buy the shares from the option holder should they exercise their right to sell.
The option writer is the mirror image of the option holder. Whereas the holder expects the stock to decline in value, the option writer has a bullish outlook on it: they expect its value to either remain the same, or increase. In both of those cases, the value of the option itself will decline, since there will be less chance of the put being profitable for the holder. This is called ‘shorting the put option.’
If an option seller wants to close their short position, they can buy the same put option in the market for the current price. This effectively cancels-out their original position and transfers their obligation to a different seller on the market.
An option seller has a higher probability of being profitable on the option trade because they have more outcomes that lead to a profit. Where the buyer of a put option requires the stock price to decrease, the put option seller can benefit if the underlying increases or stays still. However, their downside risk is also significant: in theory, the stock in question could fall in value to $0, leaving them forced to purchase something worthless if the buyer then exercises their option. Despite having a higher likelihood of profiting, the option seller takes on more risk if they are wrong.
Instead of closing their short option position, the seller may wait until the option expires or the option buyer chooses to exercise their option. If this happens, the option seller gets ‘assigned,’ and they are responsible for fulfilling the requirements of the option contract. In the case of a put option, they must buy 100 shares of the underlying stock at the agreed upon price. Their brokerage will take care of this for them, and they’ll see the difference in their account.
Getting paid to place a limit order
Selling a put option can also be a more profitable way to buy stock at a price an investor considers reasonable. For example, imagine you’re interested in a particular stock, but you’d like to wait for it to decline in price before you buy it – say, from $25 to $20. One way to do this that doesn’t involve stock options is to place a limit order on it, which will automatically purchase the shares when the stock hits the limit price, in this case, $20. Using options, however, you can do the same thing while getting paid to do so.
Imagine the same scenario. You’d like those 100 shares, and you’re still only willing to pay $20 for them. So, you set the strike price of the options contract to $20, and charge a premium of $2 per share. If the market price of the stock then falls to $20 or below, and the option holder exercises their right to sell, you still get 100 stocks for $20 each – and you also make $200 from the premium. Same scenario, more profit.
In this same case, even if the option holder never decides to exercise their right to sell, you can always just sell another put option, collect another premium, and hope to get assigned. That’s another $200 for you, and all for waiting on a stock you already wanted to reach the price you’d buy it for.
Summary
A put option is an option contract that gives the holder the right to sell shares of an underlying security to the option seller. The option holder wishes for the underlying stock to decrease in value, because it would make their put option more valuable. In some situations, a put option is purchased as insurance, and the option buyer would be satisfied if it were to expire worthless. The option seller, meanwhile, hopes the option will expire worthless so that they may keep the premium that they received without having to buy the stock in question. An option seller can also use this option as an effective way to purchase shares cheaper than the current market price.
