What Are Put Options and How Do They Work?
A put option is an options contract that grants its buyer the right (but not the obligation) to sell a specific quantity (usually 100 shares) of an asset (like a stock) at a specific price on or before the date of the contract’s expiration.
In exchange for this right, the option buyer pays the option seller a premium. A put option is considered a derivative security because its value is derived from the value of an underlying asset (e.g., shares of a stock). Investing in a put is like betting that the price of a stock will go down before the put contract expires. In other words, puts are typically bearish investments.
Put Options vs. Call Options
Put options are the opposite of call options. While puts give their owners the right to sell something at a specific strike price, calls give their owners the right to buy something at a specific strike price.
A put investor bets on the value of a security going down (which would allow them to sell shares for more than they’re worth or sell the contract for more than they paid), while a call investor bets on the value of a security going up (which would allow them to buy shares for less than they’re worth or sell the contract for more than they paid).
How Can You Make Money on a Put Option?
Investors can realize gains from put options in one of two ways—reselling or exercising.
Every option has a premium (market value) for which it can be bought and sold, and this premium changes over time based on factors like the contract’s intrinsic value (the difference between the strike price of the contract and the market price of the underlying asset), time remaining until expiration, and the volatility of the underlying asset.
To make a profit, an options trader could buy a put option for a security they believe will go down in value. If this occurs, the option’s premium will increase, and the contract holder can resell the option for its new, higher premium, pocketing the difference between what they sold it for and what they bought it for.
Alternatively, an investor could purchase an options contract with a strike price greater than or equal to an underlying security’s market price in the hopes that the security will lose value. If the underlying security does go down in price, the option holder can exercise the option and sell shares at the strike price, which is higher than the market price of the underlying asset.
It’s important to remember here that the premium an investor pays for a contract is part of their cost basis and should be factored in when deciding when to sell or exercise an option for profit. Options investors only make a profit if their gains exceed the premium they paid for the option contract in question.
How to Trade Put Options
Options like puts can be traded via most popular trading platforms like Charles Schwabb, Robinhood, WeBull, and Fidelity. Typically, however, investors must apply for approval from their brokerage before beginning to trade options. Options can also be traded directly—not through a broker—on the over-the-counter (OTC) market.
3 Common Put-Trading Strategies
There are many ways to trade puts, but the following three strategies are among the most common.
1. Long Put
A long put is probably the most straightforward put-trading strategy. If an investor is bearish on a stock (i.e., they think it will go down in value), they can buy a put option on it. If they choose an option whose strike price is above the underlying asset’s market price (i.e., one that is out of the money), there will be no intrinsic value included in the contract’s premium.
TheStreet Dictionary Terms
If the stock in question goes down in value before the contract expires, the option would gain intrinsic value by moving into the money, and the investor can either resell it for a profit or exercise it in order to sell shares of the underlying stock for more than they’re worth.
2. Naked or Uncovered Put
A naked put is actually a bullish strategy. If an investor identifies a stock that they wouldn’t mind owning (i.e., something they think has long-term value regardless of short-term price volatility) and that they think will go up in value in the short term, they can write or sell a put option on that stock. The buyer of the put option thinks the price of the underlying stock will go down, but the seller wants it to go up.
If the value of the underlying stock does go up (above the strike price), it expires worthless and the seller gets to pocket the premium of the contract. If the value of the underlying stock goes down, the buyer may choose to exercise the contract, which would result in the seller buying 100 shares above market value.
Remember here that the seller wrote the put on a stock they like in the long term, so despite the fact that they sustained a loss by purchasing 100 shares for more than market value, they don’t mind owning the shares, as they think the stock’s market value will rise in the long term.
3. Protective Put
A protective put is actually a risk mitigation strategy for an investor who is long on an actual stock (or other security). In other words, if an investor owns a stock and believes it will go up in value, they can buy put options on that stock (one contract per 100 shares they own) with strike prices equal to the price they paid for the actual shares of stock they own (or lower, depending on their loss tolerance).
If the value of the stock in question goes up (as the investor believes it will), their shares gain value, but they lose the premiums they paid for the put contracts. This isn’t a huge deal, as premiums aren’t nearly as expensive as the actual assets they derive their value from.
If, on the other hand, the value of the stock in question goes below the strike price of the contracts, the investor can simply exercise their contracts and sell their shares for the strike price. If the strike price they chose was the same as their buy-in price, they lose no money aside from the premiums paid for the contracts.
In essence, a protective put is an insurance policy an investor takes out to prevent major losses that could occur if a stock they own loses a significant amount of value.
Why Do Investors Buy Put Options?
Many investors find put options attractive because they don’t require a large amount of up-front capital. This is because puts allow a trader to profit off the downward price movement of a stock (in chunks of 100 shares) without actually purchasing the shares themselves.
Additionally, risk is limited, as the most an option buyer stands to lose is the premium or cost of the options contract itself—not the total value of the underlying shares. Shorting a stock is similar to buying a put option in that it is a bet that share price will fall.
In essence, put options allow bearish traders to bet on price drops without having to purchase, borrow, or sell real shares, which requires more capital and comes with more risk.
How Can You Tell if a Put Option Is in the Money (ITM) or Out of the Money (OTM)?
Options that have intrinsic value are considered “in the money,” whereas options that don’t are considered “out of the money.” A put option is in the money and has intrinsic value if its strike price is higher than the market price of the underlying asset (this is also called the spot price).
For example, a put option with a strike price of $60 and a spot price of $50 would be in the money by $10 because if it was exercised immediately, the resulting shares could be sold for a $10 gain. In other words, this particular put contract would have $10 worth of intrinsic value because it grants its owner the right to sell shares of stock for $10 more than what they’re worth.
Intrinsic value is always included in an option’s premium, so there would be no point in buying an in-the-money put just to exercise it right away, as its premium would incorporate its intrinsic value, so no gains would be realized. If an investor purchased the theoretical put option discussed above, they would do so in the hope that the underlying asset would continue to fall in price, causing the option’s intrinsic value to exceed the premium they paid for it before exercising or reselling the contract.
Buying a Put vs. Shorting a Stock: What’s the Difference?
If an investor buys a put option, they pay a premium for each of the 100 shares included in the contract, so if the contract expires out-of-the-money (worthless) they only lose the premium they paid.
When shorting, on the other hand, an investor borrows real shares of stock to sell (with the hope of buying them back at a lower market price later on before returning them to the lender), so if the stock goes up significantly instead of going down, they stand to lose a lot more money. Essentially, potential losses on a put are capped by the put’s premium, whereas losses on a short are not because they depend on just how much a stock goes up in price before they have to return it.