Information on Put Options

Characteristics

There are two parties involved in a put options contract, known as the holder and the writer. The writer of the contract sells it for a price and is taking on the obligation to purchase the underlying asset at the agreed price. Whoever buys the contract is known as the holder, and that means they have the right to sell the underlying asset at the agreed price if they choose to exercise their option. The stated price that the asset can be sold at is known as the strike price. The contract will also have an expiration date.

Puts can be based on a range of underlying securities. Stock in publically listed companies is common, but you can also buy them based on indices, commodities, currencies, or a combination of different financial instruments. For example, if you bought a put based on stock in a specific company, you would be buying the right to sell shares in that company at the strike price.

You don’t have to physically own the relevant underlying security at the time of buying a put. If you do not own the security this is known as a naked put. In practice, puts are rarely exercised and a monetary exchange based on the value is more likely.

Puts can be very broadly split into two distinctive categories: American style and European style. Under the terms of an American style put, the owner of the contract can choose to exercise their option at any point up to and including the expiration date. With a European style put, the owner must decide whether or not to exercise their option on the expiration date.

American style contracts are therefore significantly more flexible than European style contracts. As such they are far more common, although they tend to be more expensive because the holder must pay for that increased flexibility.

The holder of a put can also choose to try and sell the contract if they prefer. If the price of the underlying security has dropped below the strike price, it may be more profitable for the holder to sell it to another investor rather than exercising their option. This is often the case if it is a naked put and the holder doesn't actually own the underlying security.

When the price of the underlying security is below the strike price, the contract is said to be in the money. If the price is equal to the strike price the contract is at the money and if the price is above the strike price it is out of the money. These terms are applicable only when it comes to selling puts; in the money options attract higher prices for obvious reasons.

Price

What the price of the underlying security is relative to the strike price of the contract largely determines the price of a put. If you were buying a put that granted you the right to sell a security at a strike price that was above the current trading price of that security – an in the money option – then it would already have some built in profit. The amount of built in profit in the contract is known as the intrinsic value, which is one component that constitutes the market price of an option. The other component is extrinsic value.

Extrinsic value is the part of the cost that relates to the potential benefit you may get from owning the contract. The writer of contracts is exposing themselves to a risk when selling those contracts and extrinsic value essentially represents their return for taking that risk.

The market price of an option will contain both intrinsic and extrinsic value when it's in the money. Those which are out of the money or at the money have no intrinsic value and their prices are made up entirely of extrinsic value. To highlight exactly how the pricing works we have provided some simple examples.

A number of puts based on Company X stock are for sale when the shares in the company are trading at $50. The following contracts are on the market at the specified ask prices.

• $48.50 Strike Price - $1.00 Ask Price
• $50 Strike Price - $2.00 Ask Price
• $51 Strike Price - $3.00 Ask Price

The put with a strike price of $48.50 is out of the money as the stock is currently trading higher than the strike price. There is no existing profit, so the $1.00 price is purely extrinsic value. In order to be able to exercise this option for a return, you would need the price of Company X stock to fall below $48.50.

The put with the $50 strike price is at the money as the stock is trading at a price exactly equal to the strike price. Once again the price, $2.00, is just extrinsic value as there is no profit built into the contract. The extrinsic value is higher than the above example so you would only need the stock price to fall below $50 to exercise your option for a return.

The put with the $51 strike price has some built in profit as the shares are currently trading lower than the strike price. This means it's in the money, with $1.00 of intrinsic value. The $2.00 balance of the asking price represents the extrinsic value of this contract.

Benefits of Trading Puts

Puts are very useful for investors and traders as they can be used in a variety of ways. They are a straightforward way to speculate on any given security falling in value and can potentially provide a decent return without the higher exposure of simply short selling that security.

With puts it's possible to make money from falling prices without needing to trade on margin and you can also limit your exposure to risk too. They can also be used to hedge against any potential price fall of a security that you already own but choose to hold on to.

If you believed that stock in a particular company was going down too low and was short sold; you would obviously profit it did so, but you could have potentially large losses if the stock went up significantly. However, if you had bought puts based on that stock instead, your losses would be limited to the amount you had paid for them.

You would still make a profit if the stock did fall because you could either exercise your option to sell the stock at the agreed strike price or you could sell your puts for a higher price than you paid.

You can also use puts as a leverage tool to increase the potential returns on the capital you have to invest. In our section on Strategies for Trading Options we provide details of many strategies, a number of which use puts.

Please see the below examples which illustrate how buying puts can work compared to short selling a security. Although these examples are very simplified, they should give you an idea of why they can be an attractive investment. Please note, in these examples we have ignored the commissions and fees from brokers that you would incur when buying and selling stock or options contracts.

Example 1

You believe that stock in Company X, currently trading at $50, is going to fall and as decide to such short sell 200 shares. If the stock goes down by $10 to $40 you could close your position for a profit of $10 per share, which at 200 shares gives you a profit of $2,000. However, if the stock went up by $10 to $60 and you were forced to close your position to avoid any further losses, you would not gain the $2000.

Example 2

Instead of short selling stock in Company X, you decide to buy 2 lots of puts instead, with an at the money strike price of $50 and an ask price of $2.00. A lot typically represents 100 shares, so 2 lots would represent 200 shares and your total investment would be $400. With the stock going down by $10 to $40, you could exercise your options for a gross profit of $2,000. You must of course deduct your original $400 investment for net profit of $1,600. Although you haven't made quite as much as if you had short sold the stock. It's still a decent profit.

If the stock had risen, though, to $60, you are at a real advantage having bought puts. If the stock remains at $60 by the expiration date of your contracts, you have lost only the $400 you originally invested in them – as opposed to the $2,000 you would have lost by short selling the stock. Also, if the stocks rise to $60 before the contracts expire you can still hang on to them and see if the stock falls again. You cannot lose any more if they rise even further, but if they should drop below the $50 before expiration you can still make a profit.

There are a couple of downsides of buying puts as you can see. There is always the risk that your contracts expire worthless and you may not necessarily make the same level of profit as you could by short selling. The additional flexibility they offer though, together with the limited risk, makes them a very attractive trading tool.

Buying & Selling Puts

The easiest way to trade puts is to sign up at an online broker and open a trading account. You will be able to instruct your broker to execute your transactions on the exchanges just by accessing your online account. Online brokers are also typically the cheapest way to buy and sell options contracts.