The Basic Put Option
A put option provides an investor with the right, but not the obligation to sell a stock at a specific price. This price is known as the strike, or exercise price. Other important contract terms include the contract size, which for stocks is usually in denominations of 100 shares per contract. The expiration date specifies when the option expires, or matures. The contract style is also important and can be in two forms. American options let an investor exercise an option any time before the maturity date. European options can only be exercised on the expiration date. The settlement process must also be known, such as delivering the shares in the case of exercise within a certain amount of time. (See also "What is a Bull Put Spread?" and "What is a Bear Put Spread?")
Writing Put Options for Income
Buying a put option is similar to going short on a stock, or profiting from a fall in the stock price. However, an investor can also short, or write a put option. This lets him or her receive income in the form of receiving the option price and the hope is the stock remains above the strike price. If the stock falls below the strike price, the put writer has the obligation to buy the stock (because it is effectively “put” to him or her) from the put option holder. Again, this occurs if the stock price falls below the exercise price.
When writing put options, the investor who is short is betting that the stock price will remain above the exercise price during the term of the option. When this happens, the investor is able to keep the premium and earn income from the strategy.
Combining One Put with Another Option
To create a more advanced strategy and demonstrate the use of put options in practice, consider combining a put option with a call option. This strategy is known as a straddle and consists of buying a put option as well as going long a call option. In this case, the investor is speculating that the stock is going to have a relatively significant move either up or down.
For example, assume a stock trades at $11. The straddle strategy can be relatively straightforward and consist of purchasing both the put and call at a strike price of $11. Two long options are purchased with the same expiration date and a profit is reached if either the stock moves up or down by more than the cost to purchase both options.
Looking at an actual stock, shares of Staples recently traded around $11 per share. A call option trades at $0.20 and a put option trades at $0.15 for a total cost of $0.35 for a single contract. In this case, the stock would have to move up past $11.35 for the call option to start to pay off and below $10.65 for the put strategy to start to pay off.
The above put option strategies can be combined with a vast array of more exotic positions, but should provide a good introduction to the basics.
At the time of writing Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.