Put Option: What Is It And How To Use It

May 13, 2023
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Buying a put option is seen as a bearish indicator of confidence in the stock's potential. The word "put" refers to the owner's ability to "put up for sale" the underlying stock or commodity. Puts may be used as part of a broader investment strategy and, in particular, as a hedging tool when paired with other derivatives. If you possess a European put option, you are also obligated to hold the matching call option and sell the related forward contract. Put-call parity refers to this correspondence. In the stock market, put options are used to hedge against the risk that a stock's price may drop below a certain level.

What Is a Put Option?

A put option is a contract that grants the buyer the right but not the duty to sell (sell short) an agreed-upon quantity of an underlying asset at an agreed-upon price and within an agreed-upon time period. The striking price of a put option is the price at which the option's purchaser may sell the underlying securities.

Stocks, currencies, bonds, commodities, futures, and indices are just some of the underlying assets on which put options can be traded. When compared to a call option, which grants the holder the right to purchase the underlying security at a certain price on or before the option contract's expiry date, a put option offers the holder the right to sell the security at that price.

Each put contract in the stock market represents one hundred shares of the underlying asset. Puts may be bought and sold by investors regardless of whether or not they really own the underlying asset. The buyer of a put option is obligated to sell an asset at the strike price within the stipulation period. If the owner of a put option exercises such an option, the seller must sell the asset to the buyer at the strike or offer price.

Using a Put Option

The value of a put option rises as the price of the underlying stock or investment drops. On the contrary, if the price of the underlying stock rises, the value of a put option decreases. Therefore, they are frequently used for hedging reasons or as a tool for betting on price declines.

Protective puts are a common risk management method in which investors employ put options as a kind of investment insurance or a hedge to prevent losses in the underlying asset from exceeding a certain threshold. A put option purchase is made to protect against losses in a stock holding. When the option is exercised, the stock is sold by the investor at the strike price. By exercising a put option without first owning the underlying shares, an investor opens a short position in the company.

Purchase and Sale of a Put Option

  • The Purchase of a Put Option

Put options are a kind of insurance that investors purchase to safeguard their portfolios. As a possible hedge, they may purchase enough put options to cover their existing holdings. The investor is able to liquidate their position at the strike price if the underlying asset's price falls below that level. Put purchasers benefit by taking what amounts to a short sell position.

When the stock price falls below the put option's strike price before the option's expiry, the put option's owner makes money. Until the option's expiry date, the put buyer has the right to execute the option at the strike price. They sell the underlying stock to the put seller at the option's strike price, therefore exercising the option. This suggests the buyer will sell the shares at a higher price than the current market price.

  • The Put Option-Selling Process

Investors who don't want to acquire options may make money by selling them to others. The goal of a put seller is to collect premiums from buyers as the underlying asset declines in value. If a buyer exercises their put option, the seller must then purchase the underlying stock or asset at the strike price. For the put seller to profit, the stock price must either stay at or rise over the strike price.

The buyer of a put option stands to benefit if the price of the underlying stock drops below the strike price before the option's expiry date. The seller is obligated to purchase the puts from the buyer at the agreed-upon strike price, while the buyer has the right to sell the puts. A loss is possible for the buyer if the put price stays at or above the strike price.

Since exercising an option results in loss of time value, greater transaction costs, and extra margin requirements, the bulk of long option positions that have value prior to expiry are closed off by selling rather than exercising.

A buyer of a put option may lose no more than the amount of the put's premium. If the underlying stock price drops to zero, the option holder makes the most money.

Factors influencing the price of a put option

Time decay often causes the value of a put option to drop as the date of expiry draws near. Since there is less time to make a profit from the transaction, time decay increases as the option's expiry date approaches. When the temporal value of an option disappears, all that's left is the option's intrinsic value. The true or intrinsic value of an option is equal to its underlying stock price, less the strike price. An option is said to be "in the money" (ITM) if it has some underlying value.

Option Intrinsic Value = Strike Price - Market Price of Underlying Security

Neither at-the-money (ATM) nor out-of-the-money (OTM) put option has any intrinsic worth on their own. Short-selling the company at the higher market price is an alternative to executing an out-of-the-money put option at an unfavorable strike price for investors. Short-selling is riskier than purchasing put options unless the market is in a bear market.

The option's premium reflects the time value or extrinsic value. Put spreads are constructed by combining several put options on the same underlying asset. When considering the sale of put options, you should keep a few things in mind. If you don't know how much an option contract is worth and whether or not the deal will be profitable, you might lose money if the stock price drops.

The Pros of Purchasing Put Options

The versatility of put options means that investors may continue to utilize them to their advantage. Those who purchase puts do so in part to protect themselves against a possible decline in the value of the underlying stock. Other scenarios in which put options might be useful are:

  1. Reduce exposure to lose while increasing potential return. To mitigate risk, you may employ put options. While short-seller losses are infinite if the stock goes up in price, an investor hoping to benefit from the drop of a certain company may purchase only one put option to restrict the entire downside of its value. The payoff for both approaches is comparable, but taking a put reduces risk.
  2. Benefit from premium income. Selling options is one way for investors to make revenue, and it's not a bad approach if used sparingly. Selling puts may be appealing to generate additional gains, especially in a rising market when the stock is less likely to be put to the seller.
  3. Gain access to more desirable purchase prices. Put options are a tool used by investors to improve the purchase price of a stock. If they want to buy a stock that is now too costly for them, they may do it by selling put options. They may buy the shares at a discount (the premium) if the price drops below the put's strike. They get to retain the premium and try again if the stock stays above the strike.

Where to Make Option Trades

Brokerages facilitate the trading of options, including put options and other varieties. Options traders may make use of specialist tools and services provided by certain brokers. There are a plethora of options for brokers available to people with interest in the market.

Options Other Than Buying a Put

A put option buyer is not obligated to keep the option in their possession until its expiry. The option's premium adjusts to reflect changes in the stock price underlying the option. If the price of the option has increased since the buyer purchased it, the buyer may sell it to recover some of their investment and make a profit.

The option writer has equivalent capabilities. They may choose to do nothing if the underlying price is higher than the strike price. This is because there is always a chance that the option would expire worthless, allowing them to pocket the total price. However, the option writer may purchase the option back to prevent a large loss if the underlying price is nearing or falling below the strike price. The premium received is subtracted from the premium paid to close the trade to determine the gain or loss.

Contracting for Put Options

We looked at put options from the buyer's vantage point (an investor with a long put position) in the prior section. Now let's look at the short put position held by the put option seller, also known as the put option writer.

Short put options, also known as written put options, require the holder to buy shares of the underlying stock at the option's strike price rather than sell them.

Is buying a Put the same as Short-selling?

While both buying puts and short-selling are considered bearish techniques, they operate somewhat differently. Buying puts does not need a margin account and may be done with modest sums of money since the greatest loss for a put buyer is the premium paid for the put. However, the expenses associated with short selling are far higher than those of traditional trading due to risks associated with borrowing stocks and paying margin interest. This means that selling short has a substantially higher risk than buying puts.

Is it better to invest in Puts that are In the Money (ITM) or Out of the Money (OTM)?

Your trading goals, tolerance for risk, available funds, etc., are all important considerations. Since ITM puts provide the right to sell the underlying security at a higher price, they cost more to purchase than OTM puts, which have no such guarantee. However, the reduced cost of OTM puts is more than compensated by the fact that they are less likely to result in a profit by expiry. OTM Puts might be a good option if you want some degree of portfolio protection but don't want to invest a lot of money.

Is it possible to lose the whole premium I paid for a put option?

If the underlying security's price does not move below the put's strike price before the option expires, then you will lose the whole premium you paid for the put.

Should I consider writing Puts if I am just starting out with Options and have limited funds?

Put writing is a complex option technique for sophisticated traders and investors, and it requires a substantial amount of money to implement. Put writing is high-risk and not suggested for those who are just getting started with options and have a small budget.

Conclusion

Put options provide the holder with the right to sell a security at a predetermined price, regardless of the asset's current market value. That's why both hedgers and speculators might benefit from using them. Put options are among the simplest derivative contracts available. You can purchase a put option on just about everything these days, from stocks and indices to commodities and currencies. Values rise as interest rates fall, volatility in underlying asset prices rises, and the underlying asset's price declines. As the price of the underlying asset rises, the volatility of the underlying asset price falls, interest rates rise, and the time remaining before expiry grows, the value of the corresponding put option lowers.