Put options are contracts that allow for the transfer of shares of stock at a set price prior to the expiration of the contract.  The buyer of a put option has the right to sell the stock at the set price (known as the strike price) prior to the expiration of the contract.  The seller of the put option has the obligation to purchase that stock at the agreed upon price no matter what the current market price of the stock.  In this article, I will discuss the different reasons for using put options, first from a buyer’s standpoint and then from the seller’s.

One reason to purchase puts is to protect an investment portfolio from significant loss much like you would purchase fire insurance for your house or auto insurance for your car. In this scenario, a put is acting just like insurance for the buyer of the put option. As you near retirement, you may own a large chunk of stock in your employer’s stock in a retirement account such as a 401(k). Employees at Enron or Worldcom who were nearing retirement and had large portions of their wealth in company stock could have purchased put options to protect that wealth. They may not have been able to purchase the puts in the 401(k) itself but could have purchased them in taxable online brokerage accounts. As the stock of those companies plummeted, the puts would have gone up in value and could have been sold at a profit. The retirement accounts would have been wiped out, but the majority of the employee’s wealth could have been protected. More recently, employees at Bear Sterns, Lehman Brothers, AIG, and Citi could have benefited from such a strategy. I would suggest that anyone with more than 25-30% of their wealth tied up in a single stock purchase protective puts.

Another reason one might buy puts is to lock in profits on a stock that has made a significant near term gain. One of the biggest problems with stock investing is knowing when to sell. Do you sell after a 30% gain in a stock, only to watch it climb another 100%? What if it promptly turns around and the 30% gain evaporates? One way to keep holding onto a stock while “selling it” at the same time is by purchasing a put. You can purchase a put contract that expires in 2 or 3 months for about 5-10% of the price of the stock. This can lock in a 20-25% gain, effectively selling the stock at that price, while holding onto the stock allowing it to run if that is what it will do. Missing out on a small amount of profit is much better than selling early and missing out on much bigger profits.

Often when a stock or stock market makes a rather large move in a short period of time, there is a subsequent pull back.  Put options can be used to speculate on a decline in the price of a stock that you think might be overpriced.  Puts can be used as an alternative to shorting the same stock by limiting the amount of capital required to initiate a bearish position.

These 3 reasons explain why an investor might buy a put.  Now let’s look at 2 reasons that an investor might sell a put.

Many times in bullish trending markets investors will sell puts to collect the premium income without really ever wanting to own the underlying stock. They are simply hoping to benefit from the bullish trend and attempting to collect monthly returns from 3-10% by selling puts. This can work very well as long as the trend remains bullish. However, once the trend reverses itself, investors can potentially lose lots of money. It is very important to follow the general market trends and any company specific issues that can impact the stock price.

Some investors want to own a particular stock but feel that the stock is temporarily overpriced. The stock may have a pattern of trading between an identifiable point of resistance and support but is currently at the higher end of that range. Rather than just let money sit in a brokerage account, they choose to sell put options with the ultimate intent of purchasing the stock when it is in the lower end of its trading range. They choose to collect the premium on the option contracts and make a higher return on their capital than they would in a money market account. This can be a useful strategy for large company stocks that are not very volatile.

We have looked at several reasons an investor may choose to either buy put options or sell put options. These reasons range from the very defensive to the speculative. Becoming familiar with the use of put options can be beneficial for enhancing or protecting wealth.