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What Is a Put Option?
Put options are a type of options contract. These contracts allow the owner to sell a security at a specific price before the expiration date listed in the options contract. Investors buy put options to either hedge long positions or speculate that the price of a specific stock will decline. When put options are exercised, they will be worth the difference between the strike price (exercise price) and the lower market price, multiplied by the number of options represented by the contracts owned.
Call Option vs. Put Option
Options contracts allow investors to buy or sell a specific security at a designated price, prior to a defined date. Call options are contracts that allow investors to buy a stock at a designated price, while put options allow investors to sell a stock at a designated price outlined in the contract.
How Do Put Options Work?
Because the put option is a contract, there are two parties: a buyer and a seller. The seller, sometimes called a writer, gives the right to the buyer to sell the stock for a defined value. This writer makes money based on the sale price (the option premium) of the contract. The buyer of the contract gets the right to sell the stock and pays the option premium for this right.
Tip: While options are most commonly associated with stocks, investors can use other underlying assets in the options contract. These include bonds, currencies, futures, and indexes.
A put contract features an underlying investment security, expiration date, and strike price. The expiration reflects the limit date by which the contract owner has to sell the equity. The strike price is the designated price at which the option holder can sell the security.
The put contract gains value as the stock price goes down. A simple example illustrates this concept. If an investor buys an XYZ put option with a strike price of $45, they are able to gain more profit the lower the stock goes. So if the stock price drops from $45 to $35, the investor increases their potential profit by $10 per share.
Tip: In American-style options, option owners have the right to exercise the contract anytime before the expiration date. In European-style options, the contract owner can only exercise the option on the expiration date.
Intrinsic Value
Intrinsic value describes the value of a put option contract based on the difference between the strike price (exercise price) and the security's current market price.
Intrinsic Value of Put Option = Strike Price - Security Market Price
If a option contract has a positive intrinsic value, it is said to be "in the money" or ITM. An option contract with negative intrinsic value is said to be "out of the money", or OTM. If the security's market price is currently exactly the same level as the exercise price, the option is "at the money" , or ATM.
While the intrinsic value of an option can be positive or negative, an option will never carry a negative market value. Since the owner of an option is never obligated to exercise an option, they will let it expire worthless at expiry if it doesn't have positive intrinsic value, so the lowest possible market value for an option is $0.00.
Buying a Put Option Example
For example, consider an investor who buys a stock put option with an exercise price of $100, for a premium of $3 per share. A few weeks later, the stock's market price is $90/share. If the owner decides to exercise their put option, they can sell the stock for $100/share even though that's $10/share above the market price.
That makes the intrinsic value of the option $10/share. Subtracting the cost of buying the option for $3/share, the put option buyer would profit $7/share in this example scenario.
Important: A single Stock Option contract, for both Calls and Puts, represents 100 shares of the stock. So when an investor owns 1 put option contract, it's an option to sell 100 shares at the underlying price.
Since option contracts represent 100 shares each, if the put option buyer in the above example purchased 1 option contract at $3/share, the option premium would have cost them $300. Upon exercise of the option for a value of $10/share, the investor would have earned the following net profit:
(100 shares x $10) - (100 shares x $3) = $1000 - $300 = $700 net profit
Writing or Selling a Put Option Example
The investor who sells an option contract is called a writer, and the writer gives the option buyer the control of whether or not the contract is exercised. As the writer, the investor earns a premium for selling the contract.
The seller of a stock option has the exact inverse profit/loss structure of the stock option buyer. If an option buyer pays a $300 option premium for a contract, the most they can lose is $300. The option seller here would receive the $300, which is the most they can profit.
If the stock’s market price trades below the exercise price, the put option has intrinsic value to the buyer, and represents a liability to the option seller.
For example, a put writer receives $200 ($2 per share) for a contract of ABC stock with a strike price of $50 per share. The stock drops to $40 per share, and the put buyer exercises the option to sell the stock back to the option writer at a price of $50. This results in a net loss to the option writer because they have to buy the stock at $50 per share (100 shares for $5,000), but the value is only $40/share (or $4000 for 100 shares). This loss of $1,000 is partially offset by the $200 option premium received, resulting in a net loss for the option writer of -$800.
Short Selling vs. Buying a Put Option
Short selling is a bet that a stock’s market price will decline. Short selling (or shorting the stock) means that investors borrow the stock from the broker and sell it for the current market price. The goal is to buy it back cheaper if and when the stock price drops. This is risky since the stock price can appreciate, and investors may have to buy the stock for a price higher than they sold it.
Buying put options also permits an investor to benefit from a falling underlying stock price. However, put options limit an investor's risk to the cost of the option premium they paid to acquire the option. Option holders are not obligated to exercise their options, so holding an option does not represent any future liability. Since the lowest possible price for an option is $0.00, the most an option buyer can lose is the difference between the purchase price (option premium) and $0.00.
Short sellers are legally obligated to buy back the shares they sold, which could expose them to substantial, and in fact unlimited, losses.
Writing Puts for Income-Seeking Investors
Writing puts means that the investor is selling the contract and earning the premium for it. They are banking that the stock price won't trade below the exercise price, causing the option to not be exercised. This is a way for some investors to generate income in their portfolio.
How Investors Use Put Options
Investors can utilize different strategies when buying and selling puts. These strategies are contingent on their investment objectives and risk tolerance.
1. Protective Put
A protective put, also called a married put, is a way to limit the exposure investors have on a long stock position. In this strategy, investors purchase the stock itself, meaning they go long on the position. They then buy put contracts to limit the downside exposure.
For example, an investor buys 100 shares of XYZ stock at $100 per share. They then buy a put contract for $150 with the strike price of $95 per share. This limits the potential loss on the stock to $5 per share. If the stock drops to $95 (the exercise price), any further losses in the stock ownership will be offset by gains from owning the put options, thus the name "protective put".
In the above example, the maximum loss for the investor would be the cost of the put option ($150) plus the losses stemming from the stock price decline from $100/share to $95/share ($500 for 100 shares) for a net loss of -$650.
2. Naked Put Option
Naked option strategies reflect when the buyer or seller of the option has no offsetting exposure in the underlying stock itself.
A naked put option buyer is betting on profits from stock price declines below the exercise price.
A naked put option seller would sell the put option for an option premium, without any downside protection from being Short the underlying stock.
Consider an investor who writes a put option on 100 shares of ABC stock at a strike price of $95. If the shares of ABC drop to share to $85 per share, the intrinsic value of the put option would be $1,500 [100 shares x ($100-$85)], and thus represents a liability of $1,500 to the put writer. If the stock price dropped to $75 per share, the liability of the put option would amount to $2,500 for the option writer. The lower the stock price drops, the higher the losses experienced by the put option writer, because their option position is naked.
3. Bull Put Spreads
In a bull put spread the investor is both the buyer and the seller of a put option. The investor buys a put option at a certain strike price and then sells a put option at a higher strike price (higher strike than the one purchased). This investor would receive a higher option premium on the sold put option than they would pay on the purchased put option with a lower exercise price, for a net cash inflow. The investor would then hope that the stock performs well enough so that neither put option is in the money, allowing them to bank the difference between the option premium received (on the higher strike) and the option premium paid (on the lower strike).
For example, XYZ stock trades at $60 share. A bull put spread investor sells a put option with a strike price of $65 for a premium of $700 ($7 per share), and buys a put option with a strike price of $60 for a premium of $300 ($3.00 per share). The investor nets $400 in positive cashflow ($700 - $300) from the option premiums. If XYZ stock trades above $65 at expiry, both put options expire worthless, and the investor finishes with a net profit of $400. If, for example, XYZ stock traded at only $64 at the option expiry date, the $65 put option would be in-the-money and would cost the investor $100, reducing his total profit to $300.
This combination of selling and buying put option is called a bull put spread, since the investor benefits from higher prices of the underlying stock.
4. Bear Put Spreads
Bear put spreads are the opposite of bull put spreads. In the bear put spread, an investor would combine 2 put option positions to benefit from lower stock prices. Here, the investor would sell a put option with a lower exercise price than the put option purchased. This would result in a cash outflow based on the option premiums. The investor would benefit from lower share prices of the underlying security.
For example, ABC stock trades at $65/share. An investor buys a put option with an exercise price of $60 for $3.00/share ($300 for 100 shares), and sells a put option with an exercise price of $55 for $1.00/share ($100 for 100 shares). The outflow from the option premiums would be -$200.
If the share price of ABC stock drops to $55 at expiry, the purchased put option with an exercise price of $60 would be worth $500 ($5 x 100 shares), while the put option sold at an exercise price of $55 would expire worthless. The investor would receive a payoff of $500, and against the -$200 outflow for entering the position, the investor would earn a net profit of $300.
Bottom Line
Put options are derivatives that allow an investor to sell an underlying stock at a designated exercise price, prior to expiration of the contract. The value of put options increase the further the share price falls below the exercise price, and can be an alternative strategy to Short Selling. Investors can use simple put options to speculate on lower prices, or to hedge against portfolio losses. Put options can be combined with other options to bet on higher or lower prices, in a variety of structures. Writers of put options can do so in pursuit of enhancing income through received option premiums.
Derivatives strategies can be complicated. Investors should review all risks against potential rewards to ensure that a put meets their investment objectives and risk tolerance.
