Market downturns are nearly impossible to predict with any degree of accuracy. But what if there was a way to potentially capitalise even when financial markets fell?
Put options stand out in this regard. Lets understand more about put options and how to use them. The Options Clearing Corporations also offers a helpful document that discusses the characteristics and risks of options, which can be found on their website.
This comprehensive guide delves into the mechanics of put options, helping you navigate their intricacies and employ them strategically in your trading portfolio.
What is a put option?
A put option is a contractual agreement that grants the holder the option to sell an underlying asset at a predetermined price within a specific time period.
An important consideration here is lot size, which represents the number of shares the put option contract covers. It allows you to determine the quantity of the underlying asset you can sell if you exercise the option. Lot sizes vary depending on the specific financial instrument and exchange regulations.
The strike price is the agreed-upon price at which you can sell the underlying asset. It determines the potential profit or loss when exercising a put option. If the market price falls below the strike price, you can exercise the option and sell the asset at a higher price, effectively protecting yourself against further losses.
Investors often utilize put options as a form of hedging, which involves taking an offsetting position to protect against potential losses. This is done to minimize downside risk and create a safeguard against unfavorable market movements by purchasing put options.
Its essential to remember that put options come with their own risks. For example, if the price of the underlying asset remains above the strike price at expiration, the put option expires worthless and the investor loses the entire premium paid for the option. Additionally, as with all options, put options are subject to time decay, meaning their value decreases as they get closer to their expiration date.
Put option example
Let’s try to understand this better with the help of an example.
Let’s say you buy a put option for a company at a premium of $2. The lot size is 100, the strike price is $50, and the options expire in three months. You can sell 100 company shares at $50 per share within that time frame.
Let’s say the stock price drops to $40 during the option period. At this point, you can exercise the put option and sell the shares for a profit of $10 per share (strike price minus market price). Because you initially invested $200 for the put option, you will make a net profit of $800 ($10 per share profit multiplied by 100 shares minus the initial option premium cost).
Many companies listed on stock exchanges offer put options for their stocks. In the American options market, put options can be purchased through brokerage firms or online option trading platforms. Expiration dates for weekly options are every Friday except for the third Friday of a month. Monthly options expire on the third Friday of the month (no weekly options expire on those dates). In case of a holiday, the expiration date is adjusted to the preceding trading day.
Different types of put options
Put options come in several varieties depending on the underlying asset, allowing investors to hedge or speculate across different markets. Below are some common types of put options and how they are used:
Stock put option: A stock put option gives the holder the right to sell a specific number of shares of an individual stock at a pre-specified price (strike price) within a given timeframe. It acts as a hedging tool that generates profit from stock market downsides. It also offers flexibility in managing investment portfolios and can be used as a strategic tool based on market conditions and individual risk tolerance. It should, however, be noted that buyer of the stock put option could lose the premium they paid to purchase the options if not exercised.
Index put option: An index put option grants the holder the right to sell an entire market index – such as the S&P 500 or Nasdaq 100 – at a predetermined strike price within a specific timeframe. Index put options offer exposure to a broad market index rather than individual stocks. Thus, investors consider this type for diversification. It should, however, be noted that buyer of the index put option could lose the premium they paid to purchase the options if not exercised.
Commodity put option: A commodity put option gives the holder the right to sell a specified amount of a particular commodity, such as oil, gold, or wheat, at a set price within a specific timeframe. It is usually used by investors who deal in commodities to hedge against declining commodity prices. It should, however, be noted that buyer of the commodity put option could lose the premium they paid to purchase the options if not exercised.
Farmers often favor this type of option. Let’s say a farmer anticipates a price drop for wheat and wishes to safeguard their investment. In that case, they can buy a commodity put option and sell it at a predetermined price when the price drops. If the price increases instead, the farmer incurs a loss equal to the premium paid for the contract.
Currency put option: A currency put option provides you with an option to sell a specific amount of currency for another currency at an exchange rate that has already been set within a stipulated time frame. This type of option can protect against adverse currency movements and offer a certain level of control over potential exchange rate fluctuations within the agreed timeframe. It’s worth noting that the buyer of the currency put option could lose the premium they paid if it goes unexercised.
Assuming you anticipate the Euro depreciating against the US dollar, you can buy put options on the Euro to sell at a predetermined exchange rate and profit when it falls against the US dollar. However, it’s important to keep in mind that if the Euro appreciates instead, there’s a possibility of losing the premium paid for the contract.
How does a put option work?
When you invest in put options, your profit depends on market decline. The more the price of the underlying asset falls, the higher the profit margin.
Put option trading completion happens in two ways:
In the money - where your strike price is more than the actual market value of the stock in the given time. You can exercise your option and make a profit in this scenario.
Out of the money - where the option expires without any profit and you lose the premium paid for the option.
In contrast, a call option grants the holder the right to buy an asset at a predetermined price. This allows investors to make a profit if the asset increases in value.
The functioning of a put option differs from a call option in terms of rights and profit potential. Covered calls involve selling call options against an owned asset to generate income, while put options serve as a protective strategy against potential market downturns. It is important to note that buyers of the call option could lose any premiums paid for their options.
What factors affect the price of a put option?
Several factors influence the price of a put option. These include market liquidity, sentiment, overall market conditions, and specific events or news affecting the underlying asset.
Let's explore the key factors that impact the pricing of put options:
Underlying asset price: The price of the underlying asset plays a significant role in determining the value of a put option. Put options become more valuable as the price of the underlying asset decreases. A lower asset price increases the potential profit from selling the asset at the strike price. Conversely, if the underlying asset’s price rises, the put option’s value declines and potential profit decreases.
Let’s say you buy a put option on Company X with a strike price of $100. If the share price falls to $90, the put option allows you to sell the stock at $100, resulting in a $10 profit per share. However, if the stock price rises to $110, the put option loses value and profit potential is lost.
Strike price: Put options with higher strike prices are generally more expensive than those with lower strike prices. That is because put options with higher strike prices give the holder a higher potential profit if the underlying asset’s price declines significantly. The proximity of the strike price to the current market price, therefore, affects the pricing of put options.
Time to expiration: The time frame remaining until the option’s expiration date significantly affects the price of a put option. As the expiration date approaches, the time value of the put option decreases because there is less time for the underlying asset’s price to move in a favorable direction. Put options with a longer time to expiration tend to have higher premiums, as there is more opportunity for the underlying asset price to move favourably for the option holder.
Implied volatility: Implied volatility measures market expectations regarding the future price volatility of the underlying asset. Higher levels of implied volatility generally lead to increased put option prices. Higher volatility implies a higher likelihood of significant price swings in the underlying asset, increasing the potential for profits if the asset price decreases. Conversely, lower implied volatility results in lower put option prices.
Risk-free interest rate: Risk-free interest rates are other factors impacting put option pricing. Put option prices are influenced by the opportunity cost of holding the underlying asset. If the risk-free interest rate is higher, the cost of holding the asset is also higher. As a result, current prices may increase due to the increased cost of foregoing the risk-free interest rate while holding the asset.
Dividends: If the underlying asset pays dividends, it can affect the price of put options. Higher dividend payments generally reduce the value of put options. That is because the dividends offset potential losses from declining asset prices, reducing the risk of holding the asset. Putting options on assets with higher dividend yields may result in lower premiums.
Note that these factors do not work in isolation; they influence each other and react to other market conditions to determine the final price of a put option. You must analyze these factors meticulously to make informed decisions regarding the purchase or sale of put options based on your expectations of the underlying asset’s price movement.
Buying and selling: A trading guide to use put options for your advantage
Making informed decisions about when and how to utilize put options is crucial. Here are some circumstances under which buying or selling put options may make sense.
When to buy put options:
Here are the scenarios where investors generally consider buying put options:
Anticipation of market decline: When investors anticipate a decline in the price of an underlying asset, they buy put options. If the price of the asset decreases as anticipated, investors can benefit from the difference between the predetermined price and the actual market price.
Hedging against downside risk: Put options serve as a potential risk management tool for investors. By acquiring put options on existing assets, investors have the potential opportunity to offset losses by exercising the right to sell those assets at predetermined prices.
Managing stock positions: Acquiring put options grants the right to sell stocks at predetermined prices, thereby limiting potential losses. This strategy aims to safeguard investments while retaining the opportunity to participate in upside movements.
When to sell put options
Here are some circumstances where investors often sell put options:
Generating cash flow: Selling put options enables investors to collect upfront premiums, which can provide immediate cash flow. By writing put options, investors commit to buying the underlying asset at the strike price if the option is exercised. If the option is not exercised, however, investors can keep the premium as profit. This strategy allows you to generate consistent cash flow while potentially acquiring the asset at a lower price.
Acquiring the underlying asset at a lower price: For investors interested in acquiring a specific asset but perceive it as overpriced, selling put options can be considered. By selling put options with strike prices below the current market price, investors position themselves to potentially acquire the asset at a discount if the options are exercised. This approach allows investors to capitalise on market inefficiencies and potentially obtain assets at more favourable prices.
Capitalizing on neutral or bullish market sentiment: Selling put options can be a strategy considered when investors have a neutral or bullish outlook on an asset. If the asset price remains stable or rises, the put options enable investors to retain the premium collected, potentially generating income even in a non-declining market and taking advantage of favourable market sentiment.
How to write put options?
Writing put options grants the opportunity to transfer the right to sell a stock at a predetermined price to another party without imposing an obligation. This is also known as selling put options, and the option writer needs to follow these steps:
Identify an underlying asset and determine the strike price and expiration date.
Determine the premium for selling the put options.
Work with an options broker or trading platform to execute the trade as per your options trading strategy and create the contract.
If the option buyer exercises the put option, the option seller must sell the underlying asset at the strike price.
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Frequently asked questions
How do you exercise a put option?
To exercise a put option, notify your broker of your intention to sell the underlying asset at the predetermined strike price. Your broker will facilitate the transaction, allowing you to sell the asset.
How do you close a put option?
To close a put option position, you can either sell the put option contract before its expiration date or let it expire. You can capture any remaining value by selling the contract and exiting the position. If you let it expire, it has no value and your position is automatically closed.
How to calculate the put option profit?
To calculate the put option profit, subtract the put option’s premium (the cost to purchase the option) from the difference between the strike price and the actual stock price at expiration. If the result is positive, it represents your profit. However, there is no profit if the result is negative or zero.
For instance, if you buy a put option for Company A with a strike price of $50 and a premium of $2, and the stock price at expiration is $40, your profit would be $8 ($50 – $40 – $2) per share. If the stock price at expiration is $60, however, there would be no profit as the option would expire without any gain.
Various trading platforms also come with an integrated options calculator to help investors.
Why is a put option called a put?
A put option is called so because it gives the holder the right, but not the obligation, to ‘put’ or sell the underlying asset at a predetermined strike price within a specified timeframe. This distinguishes it from a call option, which provides the right to ‘call’ or buy the asset.
How long does a typical put options contract last?
There are various types of put options available. Some expire on the same day, whereas others expire after years. You can see the expiry date of each option before buying it.
Would you have a right or obligation if you sell a put option on a stock?
When you sell a put option, you are obligated to buy the stock at the stick price from the option buyer.
Is buying a put option similar to short selling?
Buying a put option and short selling are similar in that both option strategies aim to profit from a decline in the price of an underlying asset. The key difference is that buying a put option involves limited risk, as the maximum loss is limited to the option premium paid. In contrast, short selling has unlimited risk, as losses can theoretically exceed the initial investment.
Can you lose the entire premium paid for a put option?
Yes, it is possible to lose the entire premium paid for a put option. If the underlying asset’s price remains above the strike price at expiration, the put option expires, resulting in a loss equal to the premium paid.
