You can get put options explained to you in a couple of sentences, as in: a put option is an options contract that gives the buyer of the put the right to sell 100 shares (per contract) of the underlying security at a given price, by a specified date in the future. The put seller, on the other hand, assumes the obligation to buy 100 shares of the underlying stock at a given strike price, by a defined expiration date in the future.
You may have a pretty good understanding of stock options basics in both buying and selling call options, which in their simplest forms usually involve assuming risk through leverage when buying calls, and alternately, offer opportunity to reduce risk by hedging, when selling calls (also known as writing calls).
For some people though, buying and selling put options is a little harder to understand. After all, how can the put buyer sell 100 shares of something he does not own? How in turn can a put seller fulfill his obligation to buy 100 shares of stock that the put buyer does not own? In this post I’ll go over puts in such a way that even an options beginner can understand.
This confusion is easily cleared up when you recognize that this transaction is consummated simply by both parties fulfilling their obligations. In this article I will cover what happens both when the stock price is below the strike price and above the strike, at expiration.
If Stock Price Is Above Strike Price At Expiration
On the options expiration date, if the price of the underlying security is above the strike price, i.e. out of the money, then the put option will not be exercised because the right to sell shares (the put buyer owns this right) at a price that is lower than current market price would be worthless. The put would expire worthless and this would benefit the put seller, or writer, as he keeps the premium that he was paid upon entering the position. If the put seller had entered the position to hedge shares that he was short, keeping the options premium in this way will reduce his cost basis for the shares that he is short. The put buyer in this case would lose the entire purchase price of the put.
If Stock Price Is Below Strike Price At Expiration
On the other hand, if the price of the underlying stock at expiration is below the put contract’s strike price, i.e. in the money, the put option buyer will exercise his right to sell 100 shares at the strike price. If he was long shares of the stock, he has been protected by his put purchase from any decline in the stock price below the strike price. This is one way that buying puts function as insurance if you are long the underlying stock: for the premium that you paid you are protected until expiry from a fall below the strike. (Another way that puts can function as insurance is if we see a sudden appreciation in the put contract price because of a decline in the stock price, and we sell. In this case the profit from selling our put would reduce our cost basis of being long the stock, as it declines) If the put buyer was not long shares, exercising his option will leave him short 100 shares (per contract he owns) at a higher price than where the stock is currently trading: a good outcome. If this is hard to understand, just think of it this way: it is exactly the same as a call buyer exercising his call when the price of the stock is higher than the strike. His position will no longer be leveraged, but he owns the shares with a paper profit of the difference between the strike and the (higher) stock price, times 100. Ironically, in many ways getting put options trading explained to you will conceptually echo call options trading.
In this scenario, the put seller is forced to buy 100 shares of the underling stock at the strike. This means he has an immediate paper loss of the difference between the current stock price and the strike price, times 100 shares, unless he was hedging a short stock position (in which case he simple covers his short at the strike). If he is not short the shares, buying 100 shares for each of the multiple contracts that he might have written would represent a very large out-of-pocket expense.
When would you sell puts? When would you buy puts?
If you are short the underlying stock but fear that there might be a short-term increase in the price, you could sell one put contract for each 100 shares that you are short, as a hedge. If the stock price at expiry is above the strike, you keep the put premium and your cost basis for your short shares is reduced, as previously stated. Of course, the downside is that if the stock continues to go down and its price is below the strike price at expiration, as the put seller you will miss out (relative to the shares that you are short) on any downside move beyond the strike price of the put, as you are obligated to buy (in other words, cover your short in this case) 100 shares at the strike price for each contact you have written. There are other times when you might sell puts too, for instance if you decide that you like a stock but feel that it is currently too expensive. You could pick a price at which you’d like to own it, and write a put with that strike price for each 100 shares you are prepared to purchase. If it does not reach the strike you keep the premium you received, and if it does reach the strike you could buy it at that price. There is no guarantee that it won’t go still lower, of course!
You would buy puts if you are interested in taking advantage of a price decline that you’re expecting in a stock, using leverage, ie with less money than your broker would require you have in your account to go short. The potential downside of this leverage is that you could lose the entire amount that your put contract(s) cost you. The upside is that if you are correct, a given decline in the stock price will probably result in a much higher percentage gain on the money you have invested than if you had simply gone short. Stock options basics must absolutely be intertwined with an understanding of leverage.
Quality free stock option software can help you with the complexities of trading options. Also, if you feel you have not had puts addressed adequately enough, or anything about stock options explained well enough for that matter, let me know in the comments, please.