Introduction to Put Options
A put option is a contract that gives the owner of the contract the right but not the obligation to sell a certain number of shares before or on expiration date. The put option owner is the buyer of the option contract and is also known as the holder of the options contract.
On the other hand, a put option seller has the obligation to buy a certain number of shares on or before expiration date if the option is exercised by the buyer. The put option seller receives a premium in exchange for the risk that he has to take when he sells the put option.
A seller of a put option experiences risk because not only is he obliged to buy shares at a certain price (strike price of the put option contract), he is also confronted with the possibility of a huge loss. The buyer of the put option on the other hand loses only the option premium paid if the option expires worthless.
|Buyer of put option||Has the obligation to buy the underlying security|
|Seller of put option||Has the right to sell the underlying security|
A put option buyer stands to earn a limited profit. His maximum risk is a loss limited to the premium paid for the option. A put option seller stands to earn a maximum and limited profit from the collected premiums sold. The maximum risk to a put seller is limited. This is shown in the diagram above.
A stock/equity options contract gives an exposure to 100 shares of an underlying security. A buyer or a seller of a put option is thus exposed to the price movements of the underlying security.
When to Buy Put Options?
A trader will buy put options if he predicts a decline in the price of the underlying security. In this case, he is bearish and is confident that in a certain span of time, the security’s price will decrease for a number of reasons such as poor earnings outlook, negative sentiment, weak economic numbers etc. Of course, there are many reasons why a trader may predict a decline in stock prices and the list of reasons above is not meant to be exhaustive. In the real world, stock prices can go lower for any reason at all. A classic example of this is the collapse of the World Trade Center Twin Towers. That caused stock indices around the globe to drop. As a trader, you should be alert to these events. A trader can also perform economic, fundamental and technical analysis to assess the direction of the markets and the underlying security in general.
Buying Put Options Example
A trader is bearish on Company A. Company A’s stock price is now at $40. He wants to buy the current month at the money put options at $2. He pays a premium of $200 for a contract because each option contract has an underlying security of 100 shares of Company A.
His option premium paid :
$2 x 100 = $200
The company’s stock price declines to $20. His option premium increases in value to $22. He then proceeds to close the position by selling the options contract and profits from the whole exercise.
Profit per share :
$22 – $2 = $20
Profit from selling the options contract:
$20 x 100 = $2000
Net profit from this trade:
$2000 – $200 = $1800
When the stock price of Company A goes to $20, you put option is now considered in the money. Theoretically, when a put option is in the money, for every dollar move in the underlying security, there should be a corresponding and approximate dollar move in the price of the option(option premium).
As a holder of a put option contract, you can exercise the put option when it is in the money by selling shares at the exercise(strike) price if $40 and then buying it back again at $20 in the open market. You have made a net profit of :
(40 – 20) x 100 – $200 = $1800
So you can choose to close the option position or you can choose to exercise the option.
This is also known as the Long Put strategy.
Time Value Considerations
Options are assets that decline in value over time, with all things remaining constant. For example, XYZ Company is trading at a price of $50. An option seller P sells a Dec 45 put to option buyer Q. Assuming that the price of the underlying security is $50 on expiration of the option, option seller P gets to keep the entire credit or premium while option buyer Q loses the entire premium paid for the option. Hence, with all things remaining constant, options will decrease in value as the expiration date approaches. This is to the detriment of the put option buyer.
Protecting A Long Position – Protective Puts
Put options can be used in a variety of ways. One of the uses of put options is to protect the value of a long position.When you own stock in a particular company and you are convinced of the long term prospects of the company. But for some reason, there may be some negative sentiment surrounding the company that has a short term impact. You want to protect the value of the holdings in your company. Hence, you buy protective put options to hedge against the downside of the stock.
As the price of the stock goes down, the value of your put option goes up. Even though the value of your holdings have declined, this has been offset by the increase in the value of your put option.
If you have a portfolio of stocks that you’d like to protect, you may want to consider buying protective index put options to hedge against broad price movements.
As an example, an investor owns 100 shares of company TTT at a purchase price of $30. He does some fundamental analysis and finds out that the company is worth $80 in 3 years. However, over the next 12 months, there are headwinds in the form of a full blown recession. Hence, the trader buys a ATM put option. As the price of the underlying security, TTT, decreases, the value of the put increases . This helps to protect the value of the long position. However, the investor’s cost of protecting his holdings may be a hefty put option premium paid.