Have you ever wondered how you can profit from a stock or asset falling in value? Look no further than the power of put options, which can secure traders a profit when their investments go down in value!
Most new traders overlook this straightforward strategy that can help protect a portfolio or even generate a profit when the market declines. Our guide will help you understand how to use put options to maximum effect and why many beginners overlook this aspect of their trading plan when they first begin trading options online. In just a few steps, you’ll know exactly how to buy your first put option—without feeling lost in Wall Street jargon.
What Is a Put Option? (And Why You Should Care)
Put options are contracts that give the buyer the right to sell a certain asset or stock at a strike price on or by the expiration date chosen. The buyer is under no obligation to sell the asset, but they pay a premium for the right, so they can use put options as a way to hedge current investments or to speculate on a price decline. Puts can secure a profit for the buyer if the price falls below the strike price by the expiration date, and they can secure a profit for the seller (or writer) when the price stays above the strike price.
Puts Compared to Calls
On the other hand, you have call options which traders can use to speculate on price appreciation for certain assets or stocks. Buyers of call options can make a profit from a call option if the price stays the same or increases above the strike price. Call option sellers make money if the price stays below the strike. Like a put option, buyers must pay a premium for the right to sell the underlying asset at a certain price by a certain date.
What Buying a Put Actually Means
If you aren’t familiar with a lot of the terminology we have been using so far, we have included a quick glossary of terms related to buying and selling put options to give you a better idea of what’s going on.
- Premium: The price the holder of the put option pays to have the right to buy the underlying asset at a strike price and on or before the expiration date.
- Strike Price: The price at which the option holder can sell the stock to the prospective buyer.
- Expiration Date: The date that the put option is valid until. The stock price must be below the strike price on or before the expiration date for the put to profit the buyer.
- Right To Buy (Not the Obligation): The put option buyer has the right to sell the underlying stock or asset at a certain price and by a certain expiration date, but they aren’t obligated to do so.
- Profit: The put option buyer can make money on the trade if the stock price goes below the strike price before the expiration date. The profit is realized when the put option buyer sells the stock at the strike price, which is higher than the current market price.
- Loss: The put option ultimately expires as worthless if the stock price stays above the strike price, as it’s only profitable if it falls below the strike. The buyer ends up losing the premium they paid for the right to sell the asset at the strike price.
Real-World Scenario
When would you want to own a put? In a real-world example in the options trading realm, traders will want to look at stocks that are expected to go down in value, due to a wide range of factors like a rise in implied volatility or an interest rate hike by the Fed. Investors who use puts can profit when the stock or asset’s price declines in value. Puts are also a great option for investors who want to hedge a current investment that they have a call option on—the put takes an opposite position that can offset a possible loss.
Why Buy a Put Option?
Put options can be a favorable investment in a handful of cases, and we’ve outlined them in this section to show you how you can best use them to your advantage in your current trading plan.
- Protecting Your Investments: Also known as “hedging,” put options are a terrific tool for safeguarding your current investments and trades. In particular, it is “protective puts” that allow traders to bet against a call option they might have on a current stock or asset. If the position begins to decline in value, a protective put would allow the trader to bring in a profit, which could offset any losses incurred with a call option.
- Making Money When Stocks Go Down: In addition to the perk of hedging, put options can be used to speculate on stocks that you feel are going to lose value throughout the option contract you’re using.
- Anticipating a Drop in Value: If you think XYZ stock will drop, it is a great time to use a put option and simply set the strike for an amount that you see the stock value being under by the time of the contract’s expiration date. So long as the stock price is below the strike price, the trader can rake in a profit and simply close the trade out early to lock in that profit.
Getting Ready—What You Need Before You Buy
If you’re brand-new to trading online options and you’re interested in using puts on stocks and assets you envision going down in value, there are several things you will need to have ready to go, which we’ve outlined below for your convenience. Consider this a checklist on how to get started with trading put options online.
- A Brokerage Account: The first thing that new traders need is a brokerage account that has been approved for options trading. Before joining, traders must be cleared to use the platform, including having the broker run a background check on their financial situation, evaluate their investment goals, and examine their trading experience.
- Basic Requirements: Once you have chosen a broker that has been approved for options trading, it is time to complete the sign-up process for your new account. You must also provide financial information to get your new account funded with the money you’ll be trading with. If you’re looking for a good broker, we would recommend Interactive Brokers or Charles Schwab for a more advanced experience, or a platform like Robinhood or TastyTrade for a more beginner-friendly experience, including lower commissions.
- Quick Tip For Choosing a Good Broker: Look for beginner-friendly platforms with good educational tools if you’re not sure what to do. That is a great starting point, and you can’t go wrong with platforms that have a big emphasis on continuous education.
Step-by-Step—How to Buy Your First Put Option
To anyone who wants to buy their first put options, keep reading these instructions on how you can get the ball rolling. We have outlined everything in six simple steps, and you can use this as a rough guide to successfully buy your first set of put options on your stock of choice. Remember that these only profit when the asset or stocks fall in value. Any stocks you envision going up in value should be joined with call options.
- Step 1: Log in and navigate to the options trading section.
- Step 2: Search for your stock. You want to choose stocks from sectors that are expected to decline in value, at least regarding using put options.
- Step 3: Choose the right put contract (strike price, expiration date). The goal with the put option is to secure a profit when the underlying asset price falls below the strike price, so it is best to choose a strike that is at a higher value than you expect the stock price to be by the contract’s end. Select an expiration date when the put expires. Use a date that works for your time horizon, and it is likely to give your put option enough time to become profitable.
- Step 4: Decide how many contracts to buy. You determine the appropriate number of contracts by examining your risk tolerance and how much money you’re willing to risk with each trade. Keep in mind that every contract controls 100 shares of the underlying asset.
- Step 5: Review cost (“premium”) and double-check your order. You can calculate your maximum loss scenario per contract by dividing your total risk by the number of contracts you possess.
- Step 6: If everything looks correct, submit your order and monitor your position.
Pro Tip: Use limit orders to control your entry price. Limit orders are useful for letting traders specify the exact price that they’re willing to buy or sell. They are quite different market orders that execute right away after the order is placed (at the best available price).
Example Trade—Walking Through a Real-Life Put Purchase
If you’re curious as to how a real-life put purchase needs to be structured, check out a mini case study of how it could hypothetically work when trading online options. We’ll take a quick look at the ABC stock that is currently trading at $50 per share, and it is attached to an underlying that you see going down in value in the relatively near future.
- The first step would be to set up a strike price of $40 or $45 to ensure that the put option will be profitable by the time of the contract’s expiration. In this case, we will go with a strike of $45 and have the expiration date set for three months in the future.
- $45 is the price at which you can sell the stock, and you gain that right by paying the premium needed to enter the trade. In this scenario, the premium costs $3 per share. You’re dealing with 100 shares, so you effectively paid $300 for the right to sell the underlying at the strike before or by the expiration date.
- If the price of the ABC stock falls below $45 as anticipated, the trader can exercise the put option and sell their 100 shares at the strike price of $50, even though the current stock price is below $40. If the price is $40 per share, the trader can enjoy a $10 profit per share.
- You must be sure to factor in the premium of $3, which ultimately makes the total profit only $7. So long as the trader closes out the trade before the expiration date, they can secure this $7 profit per share, allowing them to gain $700.
Risks and What to Watch Out For
What are the risks and downsides associated with using put options? Keep reading to get familiar with these risks to gain a clear understanding of how using put options in your trading plan could potentially affect you, and not in a good way. You should also check out the rookie mistakes that any new trader should avoid early on to experience the best possible outcome.
Primary Risks
- The Maximum Loss: When traders buy put options, their maximum loss is limited to the premium they paid for the right to sell the underlying asset at the desired strike by or before the expiration date.
- Time Decay: The value of put options decreases the closer they get to their expiration date. Time erodes the value of the options, and this happens regardless of how the price of the underlying moves.
Avoid These Rookie Mistakes
- Overpaying: Traders can ruin their profit potential by paying more than fair market value or more than the intrinsic value of the put option if they aren’t careful. It is key to check prices at various brokers to get a gauge of the premiums being offered and how accurate they are when it comes to the underlying asset.
- Not Thinking about the Expiration Date: Even if the underlying asset moves favorably, traders can still lose their investment if they allow the contract to expire as worthless because they weren’t paying attention to the expiration date. It is critical for traders to plan their moves with firm knowledge of the expiration date.
- Not Having an Exit Plan: Traders who don’t plan out how they’re going to exit the trade can run into the problem of missed opportunities as well as unnecessary losses Before entering the trade, the trader should be thinking about keeping a conservative position size and using stop-loss orders to keep their possible losses in check and to preserve capital.
- Not Understanding How Put Options Work: Familiarize yourself with the key terms we used in our examples, explaining put options like expiration date, strike price, and others. We have included a small glossary in this review for your convenience. Going into trading without an understanding of these concepts can result in losses that could have been avoided through education and familiarization.
- Not Taking Volatility into Account: Put options can be heavily affected by volatility levels in the market. Premiums for the right to sell put options can be much lower when volatility is low. Traders can make the mistake of buying put options when volatility is high, so they’re overpaying and entering the position at a higher level than they should. It can ultimately affect profit margin as a result.
- Trading Based on Emotions: Traders can make decisions based on emotions and not their trading plan. Being guided by feelings like fear, anger, frustration, or FOMO can result in mistakes that could have been avoided by sticking with your current trading plan. Having a plan in place keeps a trader’s mode of operation far more objective and much less impulsive.
FAQs—Quick Answers for First-Time Put Buyers
What have our customers and readers been asking us about buying puts for the first time? We took the most common questions we have gotten over time and compiled them into this section to address anything that we might have forgotten when putting this review together.
What’s the Minimum Amount Needed to Buy a Put?
The cost of the premium represents the minimum amount a trader needs to buy a put option. The premium is the cost of having the right (not the obligation) of being able to sell the underlying asset at the strike price by the time of the option’s expiration date.
Can You Sell Your Put before Expiration?
Yes, you can. Selling the put before the expiration date hits lets the trader secure an early profit if the price is moving favorably. It is advantageous for the trader to realize a profit sooner rather than later because the option contract can lose a lot of value the closer it gets to the expiration date (due to the nature of theta or time decay).
What Happens if the Stock Goes up Instead?
If you buy a put option and the price of the underlying stock goes up instead of going down, the put option will most likely expire worthless, and the trader ends up losing the premium they paid to enter the trade. What a trader could do would be to buy a call option on the underlying stock (if it makes financial sense to do so) so they can make money off the stock’s appreciation. The profit here could offset the losses incurred from the put option.
How Do I Close My Put Position?
If you began the trade by buying a put option, you would close it out by selling a put option. It is the same in the opposite scenario, where selling a put (short puts) would necessitate buying to close the short put.
Ready to Make Your First Move?
It’s normal to feel a bit nervous the first time, but now you’re equipped to take action. Open your brokerage app and start exploring put options today—or practice with a virtual account first. If you need some additional information to learn more about puts before jumping in, we would encourage you to check out more beginner-friendly options guides on OptionsTrading.org—A Complete Guide to Successful Options Trading.
Downloadable Checklist: “Your First Put Option Purchase – Step-by-Step”
