Put Options: Explained For Beginners

by OTC Financial | Last Updated: 4 months ago
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Financial markets in an economy consist of various types of financial instruments.

Investors invest their surpluses in financial derivatives and financial institutions because intermediaries use these surplus funds to underwrite loans to loss-making entities.

Therefore, the options market has become very important in finance and investment markets.

Options are a type of trading in financial derivative instruments, both forex and over the counter.

Options are mainly classified as European options and American options.

These options are further divided into two categories known as call options and put options.

The main difference between call and put options is based on “rights” that have to be borne by the holder.

With a call option, the buyer has the right to buy the stock on the expiration date at a predetermined price.

In contrast, with a put option, the buyer has the right to sell the asset at a predetermined price.

What Will You Learn:

  • What is Put Option?
  • How do Put Options Work?
  • Buying a Put Option Vs. Short Selling
  • Terminology of Put Option
  • Put Option Strategy
  • Advantages and Disadvantages Put Option

What Is A Put Option?

A put option gives the right, but not the obligation, to sell the stock (asset) in the future at a predetermined price.

At the contract’s start, a put option buyer must pay a premium to the seller.

When the buyer of a put option buys a contract, he believes that the asset’s price will decrease in the future.

Like a stock contract on a call option, a put option contract also represents 100 shares.

Additionally, investors don’t need to have the underlying asset first to make a buy or sell transaction on a put option.

How Put Options Work

Put options have two main functions, namely Leveraged Speculation, and Hedging:

Leveraged Speculation

An option is a very powerful leverage tool.

You will receive unlimited profits and remember that your losses are limited.

You can lose the capital you have in just a short time.

Hedging

Like the futures market, options were used initially as hedging instruments.

Even today, options are still used as hedging by an investment institution or an individual.

But if we talk about how the put option works, it will be divided into two. It’s was:

1. Buy A Put Option

You bet that the underlying asset’s value will decrease throughout the contract when you buy a put option.

2. Sell A Put Option

Then when you sell a put option, at that time, you bet that the value of the underlying asset will increase in value or at least stay at the same value for the duration of the contract.

For put buyers, if the underlying stock’s market price moves in your favor, you can “exercise” the put option or sell the underlying stock at the strike price.

American style options allow the holder of the put to exercise the option until the expiration date, and European style options can only be exercised on the expiration date.

For a put seller, if the underlying stock’s market price stays the same or increases, you profit from the premium you paid the seller.

If the market price drops, you must buy back the option from the seller at the strike price.

Buying Put Option Vs. Short Selling

If you have done a thorough analysis and believe that a stock will decline, buying a put option is one of the best ways to profit.

However, there is one more method that is often used by traders when they want to bet on stock prices that will go down.

It is a short sell; when a person short sells a stock, the investor borrows the stock from his broker and then sells it in the market to lock in the current market price; this is done to repurchase it if and when the stock price drops.

An investor who does this will profit based on the difference between selling and buying prices.

We can conclude that put options are much more profitable than short selling.

To make it easier to understand, I will give you two examples:

Example 1:

Shares of company ABC are trading at $80 today. The $80 strike price Put Options trades at $4. 

Michael expected ABC company stock to drop and short sell 100 shares of ABC company at $80.

Then Tony also expects that ABC company shares will drop and buys 1 Put Options contract from ABC company (representing 100 shares) for $400

There are two possible scenarios:

1. The value of ABC stock rose to a price level of $110 during the put option’s maturity

Then Michael will lose $3000 (($110 – $80) x 100) from the increase in the value of the stock. And Tony will only lose $400, which is his capital when buying one put option contract.

2. ABC’s stock has dropped to $60 during the put option’s expiration date

Michael received a $2000 profit (($80 – $60) x 100) from the decline in the value of the stock.

Meanwhile, Tony received a much bigger profit with a much smaller capital than Michael, which was worth $1600

Example 2:

ABC stock is trading at $100 per share, and at a premium of $10, the investor can buy a put option with a strike price of $100 that expires in six months.

Each option contract represents 100 shares, so 1 put contract costs $1000.

The investor has $1000 in cash, which allows him to buy a single contract or short 10 shares of ABC for $100

The following table shows the results of the short-seller, Buyer Put Option, and Seller Put Option.

You can see why the put option buyer can be so excited.

As the table above shows, when the stock is down 40% from its open price, the short seller will make $400.

However, those who choose to buy the put option will feel a much greater profit than those who short sell; the profit earned by the put option buyer is $3,000 when the price has decreased by 40% from its strike price.

Therefore, it can be concluded that put options offer much better profit potential than short selling if the stock value drops significantly. 

Keep in mind that when the contract expires and the stock price doesn’t drop below the strike price, all the money invested in the put will run out.

Of course, the amount is only limited to the total money that has been used to buy one contract.

For example, like the case above, the put option buyer only lost $ 1000 even though the price rose very high from the strike price.

Short selling is the opposite, short selling offers lower profitability if the stock drops, but trades become profitable as soon as the stock moves lower.

At $95, the trade has made a profit, while the put option buyer has just broken even.

However, the most significant advantage for short-sellers is their extended time horizon for stock declines.

While the option eventually expires, the short seller does not need to close the short sell as long as the brokerage account has sufficient capital to maintain it.

The most significant drawback of short selling is that the losses are theoretically unlimited if the stock continues to rise.

While no stock has soared by thousands of percent in just a few days, short-sellers can lose more money than they put in their initial positions.

If the stock price continues to rise, short-sellers may have to raise capital to maintain their position.

Otherwise, they will experience what is known as a margin call.

Terminology Of Put Option:

Strike Price

It is the price at which you as a trader buy shares of a company and make that price the benchmark.

So it doesn’t matter if the price moves up or down; you already own stock at that price.

Holder

Holder means those who have put options.

If you buy a put option, you are a holder (buyer) of the put option.

Writer

Put Options Seller.

You are a writer if you start the position by selling Put Options.

This is called Sell To Open.

Exercise

The price at which an option offers the right to buy or sell a stock, commodity, or currency is known as the exercise price.

Only if this price is better for the holding party than the marker price will the option be exercised.

If the exercise price exceeds the market price, the put option will be used to sell the asset, and the call option will be used to acquire the asset if the exercise price is lower.

Expiration Date

Each option contract, unlike a stock, has a predetermined expiration date.

Because the time you have to buy, sell, or exercise the option contract is limited, the expiration date substantially impacts its value.

When an options contract’s expiration date arrives, it will be exercised or worthless.

In The Money

In the money, an option has value because of the relationship between the option’s exercise price (strike price) and the current market price for the underlying instrument (spot price).

A put option is in the money when the strike price is above the spot price.

At The Money

At the money is mean options have a strike price equal to the current market price of the underlying stock.

At-the-money options have no intrinsic value, but they may be profitable before expiration because they have a temporal value.

Out Of The Money

Out-of-the-money (OTM) is used to describe option contracts with only extrinsic value.

Put Option Strategy

There are many put option strategies out there, but here are some of the strategies most used by options traders:

Protective Puts

Protective Puts is an options trading hedging strategy used to hedge against a drop in stock price.

Protective Puts are very similar to Married Puts and are a popular option trading strategy amongst stock traders.

Protective Puts protect your stock’s unrealized profits so that you don’t have to sell any shares to lock in the profits so far.

Bear Put Spread

A Bear Put Spread is a bearish options strategy that profits when the underlying stock falls.

This is also one of the best bearish debit spread options strategies, capable of optimizing your potential profits for when you are sure that the underlying stock’s price will go down to an actual price and not beyond.

Calendar Put Spread

The Calendar Put Spread, one of the three popular forms of Calendar Spreads (the other 2 being the Calendar Call Spread and Ratio Calendar Spread), is a neutral options strategy that profits when the underlying asset stays stagnant or goes down slightly.

Unlike the Calendar Call Spread, Calendar Put Spreads use put options instead of call options.

Naked Put Write

Naked Put Write is sometimes known as a Put Write, Naked Put, Write Put Options, Short Put, Uncovered Put Write, Selling Naked Puts, or Short Put Options.

A Naked Put Write is when you Sell To Open Put options without first being short in the underlying stock.

It also means that you are selling a put option when you do not own that put option in the first place.

When the stock rises, the put options you sold expire out of the money, giving the full price of the put options as profit.

Advantages And Disadvantages Put Options

Put options remain popular because they offer more investing options and money-making options.

One of the allures for buyers is to hedge or offset the risk of falling the underlying stock price. Other reasons to use put options include:

  • Risk can be limited, but potential profit is unlimited
  • Very flexible, the results can go beyond short sell
  • It could be used as a hedge against stock or option positions

But with the advantages that attract a lot of investor interest, it does not mean that put options have no losses.

Like a call option, if the price moves not in the direction we predict, you will experience a loss, and all the investments you have bought the contract will all run out.

Final Thoughts

Options are a type of financial security that can be used against fluctuations in the underlying asset’s market price.

A call option gives the buyer the right to buy an asset, whereas a put option gives the buyer the right to sell the asset at an agreed price in the future.

Buying call options can be used as a strategy if the asset’s market price shows an increasing trend.

On the other hand, buying a put option can be used if the price decreases.

The point is that you have to analyze well so that you are sure the price will move according to the results of your analysis to generate unlimited profits.

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