How put options work How put options work How put options work

How put options work

Saxo Group

Put options are one of two contract options that allow an investor to buy or sell the underlying asset or security within a predetermined timeframe.

If you are looking for an alternative to short-selling an equity in the markets, read on as we explain how put options work and how to include them into your financial investing arsenal. 

What is a put option? 

A put option is a contractual agreement, giving its owner the ability to sell an underlying asset at a pre-agreed value, known as the ‘strike price’. This contract is time-limited too, with an expiry date set within the terms of the put option. 

It is the opposite of a call option, which gives investors the option to purchase an underlying asset at a pre-agreed value before the contract’s expiry date. 

Put options are another form of derivative, just like call options, due to their value being linked to another security. Every put option contract relates to 100 shares in the underlying equity or security. It’s not essential to own the underlying equity to purchase or sell a put option. 

One of the most important takeaways is that a put option gives buyers the ability to sell an underlying asset, not an obligation. An investor does not have to act on their option if the asset’s value reaches the strike price. 

The concept of a put option

It’s easy enough to buy (and sell) put options through a brokerage. Let’s say that you believe the value of equity ABC is going to fall from a price of $50 in the coming months. You would buy a put option at a strike price of $50, with an expiry date of three months into the future.

After two months, the share price of ABC has dropped to $30 per share. Your put option of 100 shares is worth $20 per share (100 x $20 = $2,000).

Most option contracts will have a premium charge owed to the broker. This charge is paid per share in most cases. Let’s say your broker charges $1 per share. You would need to remove $100 from your put option earnings, plus any other potential commissions, before getting your final profit total.

What influences the price of a put option?

The value of a put option typically falls as it moves nearer to its date of expiry. This is a concept known as time decay. As time decay inevitably occurs, the value of a put option falls as time is running out to generate a profit from the trade.

Once a put option has lost its time value, the focus then turns to its inherent value. As the name implies, this is the difference between the strike price and the underlying asset's price. If the inherent value remains, it is considered ‘in the money’ (ITM). ‘Out of the money’ (OTM) and ‘at the money’ (ATM) then the put options have zero inherent value given there is no financial benefit of the put option being exercised.

Rather than exercising the put option at an undesirable strike price, investors have the option to short-sell the equity directly instead.

Buying put options

Remember – buying a put option means you believe the value of an underlying asset will fall in value during the time of the contract. So, buying a put option can also be seen as a protective, risk-averse move to hedge against the prospect of the asset’s value declining. 

Let’s say that you currently have a long (buy) position on the underlying asset. Buying a put option can be used as a form of insurance for your long position if the asset’s value falls against you. However, if the price of the underlying asset continues to rise in your favour, all that you’ve lost is the premium charge to take out the OTM put option in the first place. This should be comfortably balanced by your gains on the underlying asset. 

Is buying a put option the same as short selling? 

Buying a put option and short selling an underlying asset are two bearish approaches to the financial markets. However, there are some key differences between them too. For instance, a buyer of put options has a capped loss from the moment they enter into the contract. 

Their maximum loss is limited to the premium charge paid to the broker. You’ll be pleased to know that brokers do not require you to have a margin account to buy puts, so it’s easy to adopt a strict bankroll management strategy with puts. 

On the flip side, short selling carries more inherent risk. Theoretically, the risk to a short seller is unlimited, because when someone short sells an asset there is no guarantee the price will fall. The price could continue to rise for years to come, leaving short sellers in a deep, red hole. That’s before you take into consideration additional charges such as margin interest and stock borrowing fees. 

For newcomers to investing, declining assets, buying puts represents a safer starting point than short selling. One way to mitigate the dangers of short selling is to develop a watertight risk management strategy with a strict risk-reward ratio and stop loss orders. 

Selling put options 

If you believe the price of an underlying asset is likely to rise in the coming months, you could look to become a put seller. By selling a put option contract, you are confident that the market value of an asset will be steady or strong in the short-to-medium term. 

As a put seller, you receive a pre-agreed premium per share to enable the buyer to purchase the options contract. However, there is much more financial downside to being a put seller. Unlike a put buyer, sellers must buy the underlying asset if it reaches the strike price. Subsequently, put sellers are required to have sufficient funds in their account or pre-agreed margin capacity with their broker to purchase the asset from the put buyer. 

A put option will not often be exercised until the underlying asset’s value falls beneath the strike price. As soon as a put option is in the money, sellers have put the stock and are required to buy it at the strike price. So long as the underlying asset’s value stays above the strike price, the put seller stays in profit thanks to the premium charge of the written put. 

There is nothing stopping put sellers to write multiple puts on the same underlying asset if they are confident in the security's stability price and are looking to earn additional premium charges. 

Why put options remain a popular investing tool 

There are several reasons for using a put option – aside from hedging against the potential for an equity’s value to plummet. 

Risk averse investors enjoy using put options to limit their exposure. For instance, an investor seeking to profit from the falling value of an equity could purchase a single put option and limit their overall downside. At the opposite end of the spectrum, those who short-sell the same equity have no definitive downside if the asset’s value was to rise rather than fall. 

In addition, put options investors can sell on their existing options to generate additional revenue if they wish. It can be a good move in a bull market, where assets are less likely to be put to the seller. 

Prospective investors in a stock that’s currently too rich for their bank may use a put option to achieve a more realistic entry point. They may sell a put option on said asset and if it falls below the put’s strike price, they can purchase the stock at the lower price and take a minor hit on the put option, which is a small price to pay for discounted entry into the asset. 

Put options in summary 

  • Put options give buyers the right – not the obligation – to sell an underlying asset if it hits the specified strike price. 
  • Put options give sellers the obligation – not the right – to buy an underlying asset if it hits the specified strike price. 
  • The price of put options varies based on the value of the underlying asset, the strike price of the put and the time to expiry of the contract. 
  • It’s possible to buy and sell put options across a broad spectrum of securities, including equities, indices, commodities, and forex. 
  • Buyers lose value in put options when the underlying asset increases in price. 
  • Sellers lose value in put options when the underlying asset falls in price. 

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