Put options are a contract that gives buyers the right to sell a futures contract before the expiration date. Buyers will then need to buy a premium from the sellers of the options. While the options contract is at a set price, the premium will depend on the terms agreed upon by the two parties.
Put options, for some, are a difficult concept to grasp, especially for newcomers looking to dive into the market. It’s important to note that unlike shares, options give you the ability to sell/buy shares within a company at a specific strike price. This gives contract buyers/holders a chance to gain a high percentage rate of returns relative to buying shares. Put options are a common way to counteract from losing too much equity when the market is dropping.
How Does a Put Option Work?
Put options trading includes many terms buyers and sellers should become familiar with. It’s important to include that there are multiple phrases to know and keep in mind when talking about options trading. These are terms used with put options and call options.
In this strategy, the trader will buy a put option anticipating the contract price to move up. When referencing the word long, one might think that it involves the share price moving up. However, the term long refers to the traders hope of selling it at a higher price at a later point in time. If the share price falls the contract will increase, and if the share price rises, the contract will decrease.
During this strategy, the trader will sell a put option without holding any position in their portfolio. In this circumstance the seller hopes for the contract to rise to receive profit. Because the writer/seller has no position, the buyer is in control of when the execution of the stock happens. The seller profits off of the premium of the stock only.
This is a strategy used in bearish markets. When the premium of the put increases while you hold it, you are making money on the contract. To go over this well use an example of a purchase of an Apple Smartwatch that had an insurance plan purchased. After buying this watch with apple care we are covered no matter.
One year later we come back to Apple Support and ask to replace a broken screen. Because we purchased our insurance plan, we are guaranteed a new screen. This is similar to covered put options. Covered put options essentially allow us to purchase contracts at set prices that we anticipate will go below strike price. Covered put options protect from significant loss of value on shares we own.
This strategy is used mostly in a bullish market but wants a buffer from potential loss. By using this strategy there is unlimited growth potential because there is ownership of the shares. Protective puts can be used on stocks, indexes and currencies. Protective trades can be used to protect from their assets.
What Are Put Options in Simple Terms?
In simple terms, put options are a tool to help hedge against risk for both parties. Most find put options beneficial for the limited liability as well as the chance to increase funds immensely from estimated drops in market values. With all options representing a set amount, trades are to be made through a broker. Typically, options trading is done over online applications like Robinhood, E*trade, Ameritrade and a number of other brokerages.
Basics of Put Options
To simplify put options, understand that they are a form of options that increases as the stock price decreases. Those who own put options purchase them at a set price to sell while the buyer will agree to purchase at that set price.
Those who buy and sell put options, are typically rewarded in short periods, since the put can gain value quickly when the stock price falls. Once the put is sold the seller receives a premium, this is an attractive trade for those looking to make money quickly.
What Is an Example of a Put Option?
Let’s use an example to understand how put options work and how to profit from them. Last year a Jane Doe company had shares selling for $100 each. Over the next 4 months the stock was evaluated to decline. The stock price went down to $90 by the fourth month.
Let’s say we bought 10 shares when they were $100. Since shares are at $90 now, this is a decline of $10 a share. We would be making a profit in this situation. Without the premium price being taken into account, we earned $100 in profits.
When Are Put Options In-The-Money?
When the strike price is above the current value for a stock it’s referred to as ITM. The holder/owner will have the right to sell the stock at a price higher than what it’s currently valued as. In the money simply means, the options have profit. We are now selling contracts at a lower price. For example, if we are holding one contract at $100, and now the stock price has fallen 10% and the stock is at $90. We have profited from the decline in the stock price.
When Are Put Options Out-The-Money?
Taking what we’ve learned from the money puts, out the money puts are the opposite. When the strike price is below the current price of the stock, there is a loss in profit. When you are selling a contract OTM, you are receiving loss from the trade. Think of it this way, if we are holding a contract at $100 a share and by expiration the contract is now $110, our prediction for the market to decline was wrong and we are now out-the money on the trade.
What Is A Put Option Spread?
Maximum profit potential is limited when using a put option spread strategy. The strategy takes place when there is an equal number of put options being sold and purchased. With this, there is less risk and which in turn means for less growth potential. Those who purchase put spreads are looking to receive profit from the markets being bearish. Put options spreads are referred to as put verticals. This is because the strikes are vertical on option tables.
What Is a Put Vertical and Why Is It Important?
Put verticals make it possible for people to trade while defining risk and the maximum amount of profit. In put vertical spreads, trades incorporate bearish and bullish put spreads. Bearish traders receive a debit when the trade seller sells their options at a lower strike price and buys the option at a higher strike price. Using put vertices allows for traders to determine strategies needed to make profit on increased, decreased and sometimes sideways movements in share pricing.
Vertical spreads are a strategy created by buying an option and selling an option with the same expiration dates but at different strike prices. Vertical spreads can be categorized in two categories when referencing put options.
Bear Put Strategy: Traders in this position will buy when they believe the stock is to fall in price. During this position traders will buy and sell a different put option that expires the same time but at a lower strike price.
Bull Put Strategy: Traders sell put options and buy a put option with a lower strike price but with the same expiration date. Bull spreads will increase in price when stock prices increase, traders will sell at this point or when they see the spread moving sideways.
Alternatives to Exercising a Put Option
There are a few alternatives to exercising put options but we will focus on rolling options. Rolling is when you simultaneously close an old trade while opening a new trade. This is a benefit when you want to break even or want to make a credit off of your contract.
When rolling is implemented it can help lower risk while letting trades have more time to establish price and adjust in your positions. It’s important to note that you still are holding a position when rolling options and not ending the contract. When rolling for credits, traders will be bringing in more money then the amount you’d have to pay to close the position, typically seen in short options.
How To Calculate the Cost of the Put Option
Before you begin trading, understanding how to determine the value of options contracts could make or save you a lot of money. To find the contract price, you need to multiply the price of the share by 100. While you can use a standard equation to calculate the amounts made, well keep in mind that time is money.
With many options trading calculators available on the market, there are a few variables needed to determine price. Most of these available calculators require the options price, the number of contracts to purchase, the current stock price and the strike price as well. Beginners use calculators to determine price, take trading and put options a step further finding and can determine how much they are really willing to spend.
Benefits Of Put Options
- Limited liability
- Because put options are used to decrease the amount of risk in a portfolio, purchasing put options is a good idea when bad news breaks over a company or industry. If the price goes down the price protects you at the strike price.
- Yield higher percentage rates
- With little money needed in order to purchase options contracts, the rewards are high. While risk is high, there is still a chance to profit from premiums.
Looking to Invest Into Put Options?
When there is uncertainty in the market, with many predicting a downward trend on certain shares, put options are the perfect way for investors to turn profits. While there is a lot of risk associated with these trades, contacting a financial advisor can save you time and money.