Investing can be a very rewarding experience. But things can get a little daunting, not to mention intimidating, with all the options out there. Most investors start off with stocks, bonds, and mutual funds (among others) as they're the most simplest and common vehicles from which to choose.
Other investments require a little more experience and/or research to generate a profit. Options trading is one of them. The more you know about how they work, the easier it will be to recognize where opportunities exist.
A put option is the opposite of a call option. In the case of a call option, the holder has the right (but not the obligation) to buy an underlying security at a specified strike price, before it reaches its expiration date. A put that is in the money has intrinsic value. In this article, we look at how put options work and how you can generate profits when they're in the money.
- Investors with put options have the right but not the obligation to sell shares in an underlying security at a certain price by a specified date.
- A put option is said to be in the money when the strike price is higher than the underlying security's market price.
- Investors commonly use put options as downside protection, which cuts or prevents a drop in value.
- Puts may give investors short market exposure with limited risk if the underlying asset's price rises.
- A put option's time value, which is an extra premium that an investor will pay above the option's intrinsic value, can also affect the option's value.
Options Contract Definition
Put Options: An Overview
An option contract is a financial derivative that represents a holder who buys a contract sold by a writer. Options can be both calls and puts. Both of these can be used to trade any number of underlying assets or securities. These include stocks, bonds, commodities, currencies, indexes, and futures.
A put option gives the holder the right but not the obligation to sell a certain amount of the underlying asset or security by a certain date (the expiration date) at a certain price. This price is called the strike price. Both call and put options can be either out of the money (OTM), at the money, or in the money (ITM). This moneyness of options (whether they're calls or puts) describes a situation that relates the strike price of a derivative to the price of its underlying security.
A put option that is in the money is one whose strike price is greater than the market price of the underlying asset. This means that the put holder has the right to sell the underlying at a price that is greater than where it currently trades. When an option is in the money, it allows for an immediate profit if the contract holder buys the shares back at the market price. Therefore, the price of an ITM put closely tracks changes in the underlying asset or security.
How Put Options Work
A put option buyer has the right but not the obligation to sell a specified quantity of the underlying security at a predetermined strike price on or before its expiration date. On the other hand, the seller or writer of a put option is obligated to buy the underlying security at a predetermined strike price if the corresponding put option is exercised.
Put options are used as downside protection, which are strategies used to mitigate—if not completely prevent—a drop in its value. The reason being is that owning the underlying asset with the right to sell it at some price effectively gives you a guaranteed floor price. Put options can also be used to speculate on an underlying if you think that it will go down in price. Thus, a put can give short market exposure with limited risk if the underlying security does, in fact, rise.
A put option should only be exercised if the underlying security is in the money.
When Is a Put Option "In the Money"?
A put option is considered in the money (ITM) when the underlying security's current market price is below that of the put option. The put option is in the money because the put option holder has the right to sell the underlying security above its current market price. When there is a right to sell the underlying security at a price higher than its strike price, the right to sell has a value equal to at least the amount of the sale price less the current market price.
Therefore, an ITM put option is one where the strike price is above the current market price. When an investor holds an ITM put option at expiry, it means the stock price is below the strike price. This means it's entirely possible that the option is worth exercising. The buyer of a put option wants the stock's price will fall far enough below the option's strike to at least cover the cost of the premium for buying the put.
The amount that a put option's strike price is greater than the current underlying security's price is known as intrinsic value because the put option is worth at least that amount.
Put options allow the contract holder to lock in a price to sell the underlying asset by a predetermined time. Remember, the put option gives the holder the right (but not the obligation) to sell the stock or asset by the expiration date at the strike price. When an option expires, it is settled. The option may expire worthless or with some value left. The underlying asset's price can make the value of a put (and a call) option fluctuate along with another factor, which is known as its time value.
The time value is an additional premium that investors are willing to pay above the option's intrinsic value. The basic formula to figure out an option's time value is to subtract its intrinsic value from the premium:
Investors are often willing to pay this premium because they believe that the value of the option will increase before it expires. An option's time value is greater when there is a greater length of time until it expires. When the option gets deeper in the money, its intrinsic value increases. Investors can use the formula above to determine how much they're willing to spend for an option. For instance, you'd want to ensure that the premium is higher than the option's intrinsic value. If not, you'll end up losing on the purchase.
The intrinsic value of any financial instrument is the measure of its worth using objective calculations instead of the current market price. ITM options have some intrinsic value, by definition.
Example of an "in the Money" Put Option
Here's a hypothetical example to show how put options work when they're in the money. Assume that you have a put option for shares in Company XYZ. This contract gives you the right to sell 100 shares of the company at a strike price of $100. And you purchased the put option at a premium of $10 with the belief that the stock price would drop before the expiration date.
Your hunch proves to be right at the expiration date and the stock price dips to $75 per share, rendering the put option in the money. You could exercise the option and net yourself a profit of $15 per share, which is the difference between the strike price and the actual price of the stock and the premium you paid ($25 - $10). If you multiply that by the number of shares (100), then you get a profit of $1,500.
Frequently Asked Questions
What Happens If My Put Option Expires in the Money?
Options can be either out of the money, at the money, or in the money. When a put option expires in the money, the contract holder's stake in the underlying security is sold at the strike price, provided the investor owns shares. If the investor doesn't, a short position is initiated at the strike price. This allows the investor to purchase the asset at a lower price.
What Is an in the Money Put Option?
A put option is considered in the money when the price of the underlying asset is lower than the strike price at the expiration date. Therefore, the exercise price is above the current market price. Being in the money allows the holder of the contract to sell the related security at a price that is higher than where it trades when the put option contract expires.
What Happens If I Sell a Put Option in the Money?
When a put option is in the money, you can choose to exercise it. This means that you can sell the shares of the underlying asset as outlined in the contract at the strike price and make a profit. This is generated by subtracting the current price of the asset from the strike price, then subtracting the premium you paid. If you choose not to exercise it, you may choose to sell the contract to another buyer.
Is It Better to Buy ITM or OTM Options?
ITM options have both extrinsic (time) value and intrinsic value, making them more expensive in terms of premium. These options also have higher deltas, making them behave more like the underlying itself. For purposes of hedging and speculation, traders will sometimes prefer OTM options because they have lower premiums and smaller deltas.
The Bottom Line
Investing in options, whether you choose to invest in calls or puts, can seem very intimidating at first. That's because there are many fine nuances that you have to wade through before you can fully understand how they work. But once you get a fundamental understanding, you may be able to generate big returns and increase your bottom line.
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