What is a Put Option
A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame. This is the opposite of a call option, which gives the holder the right to buy an underlying security at a specified price, before the option expires.
Put Option Basics
Breaking Down the Put Option
Put options are traded on various underlying assets, including stocks, currencies, commodities, and indexes. The specified price the put option buyer can sell at is called the strike price.
A put option becomes more valuable as the price of the underlying stock depreciates relative to the strike price. Conversely, a put option loses its value as the underlying stock increases. It also decreases in value as the expiration date approaches.
The value of a put option decreases due to time decay, because the probability of the stock falling below the specified strike price decreases. When an option loses its time value, the intrinsic value is left over, which is equivalent to the difference between the strike price less the underlying stock price. If an option has intrinsic value, it is in the money (ITM).
Out-of-the-money (OTM) and at-the-money put options have no intrinsic value because there would be no benefit of exercising the option. Investors could short sell the stock at the current higher market price, rather than exercising an out-of-the-money put option at an undesirable strike price.
Time value is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires.
Long Put Option Example
Assume an investor owns one put option on hypothetical stock XYZ with a strike price of $25 expiring in one month. For this option they paid a premium of $1, or $100 ($1 x 100 shares).
The investor has the right to sell 100 shares of XYZ at a price of $25 until the expiration date in one month, which is usually the third Friday of the month.
If shares of XYZ fall to $20 and the investor exercises the option, the investor could purchase 100 shares of XYZ for $20 in the market and sell the shares to the option's writer for $25 each. Consequently, the investor would make $500 (100 x ($25-$20)) on the put option, less the $100 cost they paid for the option. Net profit is $500 - $100 = $400, less any commission costs. The maximum loss on the trade is limited to the premium paid, or $100. The maximum profit is attained if XYZ falls to $0.
Short Put Option Example
Contrary to a long put option, a short or written put option obligates an investor to take delivery, or purchase shares, of the underlying stock.
Assume an investor is bullish on hypothetical stock ABC, which is currently trading at $42.50, and does not believe it will fall below $38 over the next two months. The investor could collect a premium of $1 (x 100 shares) by writing one put option on ABC with a strike price of $38.
The option writer would collect a total of $100 ($1 x 100). If ABC stays above the $38 strike price, the investor would keep the premium collected since the options would expire out of the money and be worthless. This is the maximum profit on the trade: $100, or the premium collected.
Conversely, if ABC moves below $38, the investor is on on the hook for purchasing 100 shares at $38, even if the stock falls to $30, or $25, or lower. No matter how far the stock falls, the put option writer is liable for purchasing shares at $38, meaning they face theoretical risk of $38 per share, or $3,800 per contract ($38 x 100 shares) if the underlying stock falls to zero.
Alternatives to Exercising a Put Option
The put writer does not need to hold an option until expiration, and neither does the option buyer. As the underlying stock price moves, the premium of the option will change to reflect the recent underlying price movements. The option buyer can sell their option at any time, either to cut their loss and recouple part of the premium (if OTM), or lock in a profit (if ITM).
Similarly, the option writer can do the same thing. If the underlying's price is above the strike price they may do nothing because the option may expire worthless and they can keep the whole premium. Buf if the underlying's price is approaching or dropping below the strike price, to avoid a big loss the option writer may simply buy the option back, getting them out of the position. The profit or loss is the difference between the premium collected and premium paid to get out of the position.