by Ian Harvey
Put options are one of the two primary classes of stock options. The basic principle of trading these options is that if the price of the stock on which you buy an option falls, you make money.
These options have the opposite purpose to a call option, and give the buyer the right, but not the obligation to sell an agreed amount of stock (usually in lots of 100 shares) to the seller of the put option before the expiry of the contract. The sale of the stock may be made at a predetermined price, known as the strike price. The expiry date depends on the duration of the contract.
This simply means that you, as the option buyer, are entitled to sell shares of a stock at a fixed price up until the expiry date- regardless of what the stock is worth at the time. The seller of the option is obliged to buy the stock, even if the price they must pay you is much higher than the current market value.
With buying any options, you pay a fee, or premium, to the seller of the options. This option premium is a fraction of the cost of the underlying stock, and rises or falls proportionally. (In the case of put options, the value of the option rises if the stock price falls.)
It is interesting to note that the cost of a put option is usually less than the cost of a call option for the same stock. This is because there are generally a higher number of investors who take a bullish, rather than bearish, approach to trading.
If a call option on a share with a market value of $25.00 costs $1.20 per option, a put option may cost $1.10. Investing in a lot of 100 of these options would mean an outlay of $110.00 plus the commission paid to the broker of the sale.
Selling the stock is known as exercising the option, and this can obviously only be done if an investor actually holds shares in the stock. Owning shares in the stock is a separate investment to purchasing the option.
Buying an option when an investor does not hold shares in a stock is done in the belief that the stock price will drop, and that the option price will rise accordingly. The option can then be sold at a higher price than the purchase cost, generating a profit.
These options are frequently used to protect an investment in stocks from losses in the event of a market decline. To use put options in this way is much like purchasing insurance. By paying a premium to purchase an option on stocks that you currently have an investment in, you are covering yourself against possible losses.
If the market value of the stock decreases, there are two ways that an options trader can recoup the losses that their shares incur. The first way is to sell the options contract, which has increased in value proportionately to the decrease in stock value, at a price higher than it was purchased for. This can help to off-set the capital loss that the stock has sustained.
Another possible way to cover losses in a market downturn is by exercising the option, which means selling the stocks at the strike price, which at this point is higher than market value.
Protecting stock investments is only one way to utilize put options. You do not have to own shares in a stock to make use of a put option. These options can also be used, very profitably, and at a fairly minimal risk, as speculative trading instruments. This means that options can be purchased on a stock that the investor believes will drop in value, with the aim of selling the option at a proportionately increased price, and making a profit during bearish market conditions.
In trading put options, the profit that you can make is limited only by how low the underlying stock price falls within the period of the option contract. If the price of the stock has fallen from $25.00 to $23.00, a conservative estimate is that the options you bought for $1.10 would have risen to $1.30.
One profit-making strategy is to sell these options, which cost you $110.00 for a total of $130.00, generating an immediate profit. Alternatively, you can hold onto the options if you believe that the stock price will continue to drop further, and sell them closer to the expiry date for an even bigger gain.
If the stock price rises, or fails to drop below the strike price, the risk is limited to the cost of the premium and commission. If the stock price rises, the option price drops accordingly. If you hold onto the options in the hope that the trend will reverse, and you fail to sell the options before they have expired, they will become worthless.
The choice of whether and when to sell depends on your confidence that the drop will be reversed within the time of your contract. If you do not expect the the value of your options to rise again, you may choose to cut your losses. This can be done by selling your options at a percentage of what you paid for them rather than risking the full cost of the premium by holding onto the options.
This is a basic outline of put options, the simplest ways that they are used in options trading, and how to profit from trading them.