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How put options work
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Key takeaways:
- A put option gives the buyer the right, but not the obligation, to sell an underlying asset at a strike price before the expiry date. As a derivative, its value depends on the price of the underlying security rather than ownership of the asset itself.
- The concept of a put option is mainly bearish: buyers typically use put options when they expect the underlying asset to fall in value. If the market drops below the strike price, the put option may gain intrinsic value, although premiums, fees and time value still affect the final outcome.
- What influences the price of a put option includes the underlying asset’s price, the strike price, and time to expiry. Time decay reduces an option’s time value as expiry approaches, while intrinsic value only exists when the put is in the money.
- Buying put options can be used either to speculate on falling prices or as a hedge against an existing long position. This can help limit downside to the premium paid, but put options are still complex, may expire worthless, and are not suitable for everyone.
- Selling put options is a different strategy because the seller receives the premium but takes on the obligation to buy the underlying asset if assigned. Put options remain a popular investing tool because they can be used for hedging, bearish exposure, or entry strategies, but the risks for put sellers can be substantial.
Put options are one of the two main types of 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 use them as part of an overall approach.
It’s important to understand that options are complex products and involve significant risk. You can lose the full premium paid (and option sellers can face substantial losses). Options aren’t suitable for everyone.
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. Many listed equity options (for example, in the US) have a contract multiplier of 100 shares, but contract size varies by market and instrument (and may differ for indices, commodities, FX, or adjusted corporate actions). 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 possible 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. The option’s intrinsic value would be $20 per share (before considering time value), and the option’s market price could be higher or lower depending on volatility and time to expiry.
Option buyers pay a premium to the option seller, and brokers may also charge commissions/fees depending on the account. 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?
All else being equal, a put option’s time value typically falls as it moves nearer to expiry. This is a concept known as time decay. Time decay generally reduces an option’s time value as expiry approaches.
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). If a put is in the money (ITM), it has intrinsic value (strike minus underlying price). If it is at the money (ATM) or out of the money (OTM), it has zero intrinsic value (though it may still have time value).
Instead of exercising, traders may sell the option before expiry or use other strategies, but alternatives (including short selling) depend on availability, costs and risk.
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. Buying a put can be used as a hedge, but it has a cost (the premium) and may expire worthless. If the underlying rises, the put can lose value and the premium may not be offset by gains depending on position size and timing.
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 may be partly offset by gains on the underlying asset, depending on position size, timing and market moves.
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 generally limited to the premium paid, plus any commissions/fees. Account requirements vary by broker and jurisdiction. Buying options typically requires options trading approval, and some brokers may require a margin-enabled account even for option buying.
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.
Buying puts can cap loss to the premium paid, but options are still complex and risky, and may not be suitable for everyone. Short selling carries significant risks, and risk controls (such as position sizing and stop-loss orders) may help manage risk, but they do not eliminate it (and execution can be worse than expected in fast markets).
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. Put sellers can be assigned and required to buy the underlying asset if the option is exercised (including possible early exercise for some options). 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 is generally only exercised when exercise is economically worthwhile, and whether it can be exercised before expiry depends on the option style. If a short put is exercised or assigned, the seller may be required to buy the underlying asset at the strike price. If the option expires worthless, the put seller may keep the premium received, subject to costs and any earlier close-out or assignment.
Selling multiple puts increases exposure and potential losses; requirements and limits depend on margin rules and broker policies.
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.
- Option buyers lose value in put options when the underlying asset increases in price.
- Option sellers lose value in put options when the underlying asset falls in price.
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