Put Options Explained

Put Options Explained

To have put options explained in any kind of fairly understandable way requires quite a bit of “literary finesse”, so I am offering this meager attempt to do so by means of this hub. “Why,” you may ask, “does the investment world have to be filled with so much complicated jargon and complex terminology?” I have absolutely no clue, but let me tell you, the finance and investment community just loves to create new technical jargon and fancy buzzwords that make what they do sound really spectacular. I actually think that many of them do so because they have to justify their jobs, but that’s a whole other story. But on to the business of put options. Basically, don’t let the word “put” fool you, because although it is commonly recognized as a verb, that pretty much has nothing to do with anything where put options are concerned. In a roundabout way it does, because shares of a stock (or a contract of a commodity) are literally being “put to” someone when you have to exercise the put option, but I’m getting ahead of myself, and really that doesn’t have too much of a bearing on how put options are commonly used, because most put options are liquidated or traded back onto the market long before they expire. A put option, in simple terms, is a contract that gives you the right (but not the obligation) to sell 100 shares of stock at a predetermined price (called the “strike price”) within a set time frame, as all options do have an expiration date. Put options are normally bought when the investor has a bearish sentiment on a particular stock (meaning, he/she believes that the stock will go down), and they are sold (or “shorted”) when the investor believes that the market will go up. I will mainly focus on long puts (a.k.a., put options that you buy) rather than short puts (or, put options that you sell), as a conversation on short puts is a whole other hub—and actually probably a whole other series of hubs.

Image courtesy of Google Images
Image courtesy of Google Images

An Explanation of Put Options

Let’s say that you’ve been watching ABC stock for quite a while now, and you believe that the price of the stock will go down. Let’s say that the stock is currently trading at $40.00 per share. If you were to buy a put option, what that would mean is that you are purchasing a contract that basically gives you the right, but NOT the obligation, to sell 100 shares of ABC stock at a fixed price (a.k.a. the “strike price”) in the future. It’s almost like shorting the stock outright, because you make money as the stock’s price declines. Let’s think about it: If ABC is trading at $40.00 per share, and you believe (based on your research) that ABC is going to drop like a rock, you could buy a put option with a $35.00 strike price. If the stock’s price does indeed go down, the put option increases in value. Remember that each option represents 100 shares of stock, so let’s say that the price of ABC kept freefalling down to only $20.00 per share. Since you bought a put option with a $35.00 strike price, this would mean that your put option is what they call “in-the-money” by $15.00. What this means is, you now are sitting on at least $1,500.00 profit, since again, this option is representing 100 shares of stock ($15.00 x 100 shares). At this point, you could do one of two things: you could exercise the option, which means you would basically “cash it in” and this means that you would automatically be short 100 shares of ABC stock at $35.00 per share, even though the actual stock is trading at $20.00 per share. It is helpful to mention here that you really need to understand the difference between going long versus going short, as this is one of the foundational principles that you have to understand to be able to trade options successfully. But anyway, you would then be short 100 shares of ABC stock, at a price that’s $15.00 above where the market is currently trading, so this is a good thing! You could then immediately buy back the 100 shares of stock at $20.00 per share (or, “cover your short” as they call it), and exit the trade with $1,500.00 profit. The other route to take is not to fool with exercising the option at all, and just simply close out the position by liquidating the put option at a profit, because again, put options increase in value as the stock’s price declines. Now as to the what the exact value of the put option will be when you offset it, it’s not always easy to determine, as the factors that drive the value of options (such as time, intrinsic value, extrinsic value, all of which I don’t have time to go into) can vary. But, it’s safe to assume that since you’re $15.00 “in-the-money” with this particular option, you will more than likely have at least $1,500.00 of profit on that option. So, to simplify and summarize, if you buy a put option and the price of the underlying stock goes down, you make money. If you buy a put option and the price of the underlying stock goes up, you lose money. Simple as that. This hub is long enough, so I’m out!   

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