• Put Option

    A put option allows the owner the right but not the obligation to sell a specific quantity of an investment vehicle at a named price within a predetermined period of time. That is a super simple definition, now we’ll get to some more particulars.

    An option is an agreement, a contract, between a buyer and a seller for the right but not the obligation to buy or sell a security (for which the option is a derivative). There are call options, but we will only discuss put options for now.

    A Few Basics of the Put Option

    Strike Price, Option Chain, Expiration
    The strike price is the price that moves the trade. The option chain shows the prices of puts on the right. If you are trading stock put options, you will buy or sell the options in increments of 100. The traded price will be 100 times the amount listed on the chain. Most brokers supply real time option chain access in their trading software. Expiration is the last day the stock option can be sold, bought, traded, or exercised. Once expiration is over, the option is worthless. Expiration dates can vary from one month out to more than a year (LEAPS options). There are different option exercising rules depending on the option style and even the exchange (A European put option has a shorter expiration period than does an American put option).

    In, At, and Out of the Money
    When the strike price is less than the price of the stock it is “in the money.”
    When the strike price is equal to the price of the stock it is “at the money.”
    When the strike price is more than the price of the stock it is “out of the money.”

    If you are the writer (seller) of a put option, you have entered into a contract with a buyer. The buyer paid you a premium for the right, but not the obligation (as above-stated) to sell you the underlying security for a certain amount (the strike price) by a certain date (the expiration). As the writer, you are obligated to buy that underlying security at the strike price if the owner of the option so desires to exercise his option.

    Obviously, the seller (writer) of the put option is hoping the price of the underlying security goes up and the buyer of the put option is banking that the price will go down.

    The simplest way to go about put option trading is to buy a put. If you believe the price of the security represented by the option is going to decline below the strike price of the option, then you of course want to buy a put option and at expiration exercise your option to sell that underlying security at a price higher than the current price.

    Various Put Option Strategies

    Stock Put Options

    Stock options are traded in contracts that represent 100 shares of the underlying stock. This is an example of what is called a “long put strategy.”

    For example: You see that Company ABC is trading at $50 per share. You review the option chain (a listing of all strike prices and the premiums for those corresponding options) and you see that a put option with a strike price of $50 which expires this same month (the third Friday) is being sold for $4. Now, if you believe the share price of Company ABC is going to slide below that $50 per share by the expiration date, you would probably be interested in buying one or more contracts. Let’s say you bought one contract and paid the writer/seller $400 ($4 x 100). You have now entered into a contract that gives you the right but not the obligation to sell those 100 shares of Company ABC upon expiration for $50 per share, or $5,000. Now, of course, if you decided to exercise your option, you would have to buy 100 shares of Company ABC first, but if upon expiration the $50 per share price has slid to $35 per share, as you thought it would, you could buy 100 shares for $3500, and immediately sell the same for $5000. You thereby have just made a profit of $1100 ($5000 – $3500 – $400 = $1100). Of course you would have to factor in the commission you paid also, so your met profit would be less than $1100.

    There are many put strategies that traders use such as the “protective put strategy.” This is when you currently own stock and by holding put options, it offers you some protection against a loss in share price.

    Selling/Writing Put Options

    You can also sell or write put options. Obviously when you sell a put your plan is the reverse of the put buyer: you are hoping that prices go up and the option will expire worthless and you get to keep the premium the buyer paid you. This is a little more risky than buying puts, but if you are careful and do the research, you can make some handsome profits.

    Covered Puts
    This is when the seller already is in a position with the underlying security and he is obviously bearish on it.

    Naked Puts
    This is when seller is not in a position with the underlying security and he obviously is bullish on it. Writing naked puts (if done correctly) is a way to acquire stocks at a discount.

    Put Spreads
    This is a more complicated strategy wherein equal numbers of put options are bought and sold at the same time on the same underlying security, but each with different strike prices and sometimes different expirations. A spread is created thereby limiting the potential loss; however, at the same time it cuts off a higher profit, but it’s a form of insurance and works well.

    Put Options on Different Instruments

    There are many more complex investment strategies that use put options as a form of insurance in different ways. The most popular put options trading is on stock or equities, but they are also traded on other instruments: interest rates, commodities and futures.

    While it is somewhat complicated put option trading is a great way to maximize your gains, while minimizing losses.

    © 2011, www.daytraderoptions.com. All rights reserved.

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