Put Options is one of the two types of options, with the other one being Call. A put option is a contract that gives the buyer the right to sell the underlying security/asset at a certain date and price in the future. The underlying asset could be anything, such as shares, commodities, bonds, or more. The buyer of this option makes a profit if the price of the security goes down.
A point to note is that the buyer of the option is not under the obligation to exercise the Put option. However, here the seller is indebted with an obligation. Because if the buyer elects to exercise the right to sell, then the seller has no option but to buy the contracted security from the buyer of the put option. Further, a buyer can use the option anytime before the maturity of the option. The writer of the option gets an option premium for the risk they take.
A put option is profitable for the holder if the market is bearish. This is because even if the price of the security goes down, the holder will be able to sell it at a higher price (strike price) by exercising the option.
How Put Options Work?
A put option or any option per se can have three variants – Out of the Money, At the Money, or In the Money.
A put option becomes Out of the Money (OTM) whenever and wherever the strike price is lower than the market price of the underlying security. In this case, the holder will not exercise the option, and the option would get worthless upon expiry. Instead of selling and honoring the contract, the buyer would be better off selling the security in the open market that commands a price over and above the strike price or contracted price.
A put option becomes At the Money (ATM) if the strike price and the market price are the same. In this case, again, the holder will not exercise the option, and it would get worthless upon expiry.
A point worth noting is that holder will only make a net profit if the amount of option premium is less than the difference between the strike price and stock price at the expiry.
Suppose a holder acquires a put option for $2 and at a strike price of $10. Now suppose the price of the underlying is $8 at the expiry. In this case, the holder will gain $2, but the net profit will be zero due to the option premium.
Why Sell a Put Option?
Please note that for every put option that the holder buys, there is a put option that the other party sells. Selling the put option is the exact opposite of buying it. While the buyer believes that the price of the security will move downwards, the seller of the put option expects the price of the underlying asset to move up the strike price or remain the same. In such a case, the seller’s gain equals the option premium he receives on selling the option contract.
The payoff for the put option seller is the opposite of the buyer. The sellers’ primary motive in selling a put is that they get the money (option premium) upfront. And, they may never have to buy the asset if the price is above the strike price. In this case, the writer or the seller will make a profit.
However, the profit of the writer is limited to the amount of premium they get. This may appear a low-risk strategy, and it is if you are bullish on the stock. But, if the price of the underlying plummets, then the writer can incur heavy losses. In such a case, the writer will also have to maintain enough money in their brokerage account to cover such losses.
Put Option Strategies
A holder can use the different put strategies to maximize their profit and/or minimize their loss. These are:
This is the most basic put strategy. The holder of the option here believes the price of the underlying will drop in the time ahead. Now, if the price of the underlying drops near the expiry, the holder will exercise the option and make a profit.
We also call this strategy “naked put.” In this strategy, the holder of the option actually believes the price of the underlying will go up or be the same as the strike price. Thus, this strategy is more bullish than the long put strategy. This strategy is primarily for the seller or writer of the put option. The seller here aims to net the option premium that they get for taking the risk.
However, this strategy carries a much higher risk, and the loss potential is limitless. It is due to the price of the security may virtually go to zero. In this case, the writer will still have to acquire the asset at the strike price.
From the point of view of the writer, it is profitable if the price of the security stays above the strike price.
Bear Put Spread
In the long put, the holder is more bearish on the asset price. Similarly, in a bear put spread, the holder is also bearish on the asset price, but only moderately. To execute this strategy, the holder will first short an “out of the money” put and, at the same time, buy an “in the money” put option, but at a higher price. Both the trades will have the same expiration date, as well as units of the underlying asset.
In this strategy, there are no limits to the profits, and there is a cap on the losses. The holder can lose the money that they have paid for the spread. For the holder, the worst-case scenario is the share price moving above the stock price. In that situation, both the contracts – OTM and ITM will be worthless at the expiry.
We also call this strategy “married put.” Similar to the covered put, this strategy allows the holder to protect a long position on the underlying asset. As the name suggests, such a strategy gives the holder the protection and thus, works as an insurance policy.
The holder purchases a put option for every share they own to execute this strategy. In case of a drop in the stock price below the strike price, the holder will lose the money directly on the shares. But, the holder will make gains by using the put option. Or, we can say, the holder will be able to minimize the losses by the amount the put option is ‘In the Money.’
Put Options vs. Short Selling
Short selling is a good alternative to buying a put option. This is because you also expect the stock price to drop in the future in short selling. Still, the two strategies are distinct.
In short selling, an investor effectively borrows security, which is not the case with the put option.
One more difference between the two is of payoff. An investor can gain more using a put than by shorting a share. In a put option, the maximum loss that a holder can incur is equal to the amount of the option premium. But, in the case of short selling, the losses will rise if the share price increases and continue to rise until you buy the stock to close the position.
Put Options Risks
A put option can be a good way to better the profit at a time when the market is in a downturn. However, a point worth noting is that put option (or options trading in general) is not for beginners. It is true that options give users flexibility, as well as the opportunity to make more profit, but it is not without risks.
To trade options, an investor must know all about options trading. This is because it is very important to understand every term and concept of option trading. Even a small mistake could result in massive losses.
One of the biggest risks for options traders is time decay. This means the value of options decays with time. Or, we can say that as the contract gets closer to the expiry, the less time security has to move in either direction. The longer duration contracts are one way to reduce the time decay risk.
Implied volatility is another risk that options investors have to face. This volatility suggests how volatile the market could be going ahead. Similarly, volatility is also a risk that investors face. This is the risk of fluctuation in the price of the underlying asset. So, if the price of the security is highly volatile and the price starts moving in the opposite direction, an investor could lose a massive amount of money.
Owing to the existence of such risks, it is very important that put option (option trading in general) traders have enough experience and understanding of the market.
Also, read – Put and Call Options.
Frequently Asked Questions (FAQs)
Short selling is a good alternative to buying a put option. In short selling, an investor effectively borrows security, which is not the case with the put option. One more difference between the two is of payoff. An investor can gain more using a put than by shorting a share.
The risks that are associated with put options are:
1. Time decay: The value of options decays with time. Or, we can say that as the contract gets closer to the expiry, the less time security has to move in either direction.
2. Implied volatility: Suggests how volatile the market could be going ahead. This is the risk of fluctuation in the price of the underlying asset.
A put option can be a good way to better the profit at a time when the market is in a downturn. However, a point worth noting is that put option (or options trading in general) is not for beginners. Owing to the existence of certain risks, it is very important that put option (option trading in general) traders have enough experience and understanding of the market.