What Is a Put Option?
A put option is a contract that gives its holder the right to sell a set number of equity shares at a set price, called the strike price, before a certain expiration date. If the option is exercised, the writer of the option contract is obligated to purchase the shares from the option holder. "Exercising the option" means the buyer is opting to take advantage of the right to sell the shares at the strike price.
The opposite of a put option is a call option, which gives the contract holder the right to purchase a set amount of shares at the strike price prior to its expiration.
How Put Options Work
There are a number of ways to close out, or complete, the option trade depending on the circumstances.
Example of a Put Option Transaction
Max purchases one $11 put option on Ford Motor Co. (F). Each option contract is worth 100 shares, so this gives him the right to sell 100 shares of Ford at $11 before the expiration date.
If Max already holds 100 shares of Ford, his broker will sell these shares at the $11 strike price. To complete the transaction, an option writer will need to purchase the shares at that price.
Max realizes a gain on the option if the price of Ford stock falls below the $11 strike price. Say the share price falls to $8. He would be able to sell 100 shares at $11 instead of the current $8 market price. By buying the option, Max has saved himself $300 (less the cost of the option), since he has sold 100 shares at $11, for a total $1,100, instead of having to sell the shares at $8 for a total $800.
Max could have sold his stock at $11 and not bought a put option. But he apparently thought the stock price could rise. He didn't want to sell the stock, but he did want protection in case the stocked dropped. He was willing to pay the option premium for that protection.
Example of a Short Position Transaction
Now let's assume that Max does not actually own shares of Ford, but has bought the $11 put and the stock is currently trading at $8. He could purchase shares of Ford at $8 and then have the broker exercise the option at $11. This would net Max $300, less the cost of the option premium, fees, and commissions.
If Max doesn't own shares, the option can be exercised to initiate a short position in the stock. Since Max doesn't own any shares to sell, the put option will initiate a short position at $11. He can then cover the short position at the current market price of $8, or continue to hold the short position. Initiating a short position requires a margin account with enough money in it to cover the margin on the short trade.
Selling the Option
The other alternative to exercising an option is to sell the option back to the market. This is the simplest approach and is how most option trades are closed. There is no exchange of shares. The trader simply makes money off the change in the option price.
For example, the $11 put may have cost $0.65 x 100 shares, or $65 (plus commissions). Two months later, the option is about to expire and the stock is trading at $8. Most of the time value of the option has been eroded, but it still has an intrinsic value of $3, so the option may be priced at $3.10. Max bought his option for $65 and can now sell it for $310.
In the scenarios above, you add in the cost of the option ($65, in this case) to calculate the net advantage from exercising the option.
Selling the Put
Option premiums are in constant flux, and purchasing put options that are deep in the money or far out of the money drastically affects the option premium and the possibility of exercising it.
Closing out a put trade by simply selling the put is popular because most brokers charge higher fees for exercising an option compared to the commission for selling an option.
If you're considering exercising an option, find out how much your broker charges to do so. This could have a material impact on your profits, especially on smaller trades.
Broker fees vary widely. If you're thinking of starting a trading account, Investopedia has created a list of the best options brokers to help you get started.