How and When to Buy a Put Option

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. The distinction between the payoffs for a put and a call is important to remember.

  1. Placed strategically, a put can save a trader from a loss, or create gains.
  2. You’ll see them listed with every option contract, and how they are calculated is pretty 🤓.
  3. You would prefer not to sell them, but you’re nervous the stock might be ready to decline in price.
  4. Investors buy put options as a type of insurance to protect other investments.

If a put option is not exercised by the expiration date, the option becomes worthless. The investor would lose the premium they paid for the put option. One alternative to buying puts is short selling, as you’re betting against a stock in both cases.

If the stock falls far enough in value you will receive a margin call, requiring you to put more cash in your account. A put owner profits when the premium paid is lower than the difference between the strike price and stock price at option expiration. Imagine a trader purchased a put option for a premium of $0.80 with a strike price of $30 and the stock is $25 at expiration. The option is worth $5 and the trader has made a profit of $4.20.

For example, if you buy an option with high volatility, something could happen that makes investors’ perception of the underlying asset’s volatility drop. Then, the value of your option can drop, too — even if the underlying asset price stays the same. This happens because the lower difference between data and information implied volatility means the stock’s future movement is more certain. You may have paid $100 for that option a week ago, but now it could be worth $5. An option contract usually represents 100 shares of the underlying stock, but the price (called the premium) is quoted per share.

What are the different types of options?

If the stock stays at the strike price or above it, the put is “out of the money” and the option expires worthless. Then the put seller keeps the premium paid for the put while the put buyer loses the entire investment. American options can be bought or sold at any point between the date of purchase and the expiration date. Many investors favor this type of option, since you can capture profit as soon as the stock price moves. But you’ll typically have to pay a higher premium to take advantage of the early exercise provision. Both short selling and buying put options are bearish strategies that can reap substantial benefits.

The strike price in a put Option is the predetermined price at which the underlying asset can be sold if the investor chooses to exercise the option. Higher levels of volatility in the market or the underlying asset can increase the value of put options. Greater uncertainty translates into higher expected price declines and, thus, a higher option value.

When can you exercise an option?

It really depends on factors such as your trading objective, risk appetite, amount of capital, etc. The dollar outlay for in the money (ITM) puts is higher than for out of the money (OTM) puts because they give you the right to sell the underlying security at a higher price. But the lower price for OTM puts is offset by the fact that they also have a lower probability of being profitable by expiration. If you don’t want to spend too much for protective puts and are willing to accept the risk of a modest decline in your portfolio, then OTM puts might be the way to go. For a put writer, the maximum gain is limited to the premium collected, while the maximum loss would occur if the underlying stock price fell to zero.

However, if the stock doesn’t move as you expected, your put option may expire worthless, meaning that you could lose the premium you paid ($1 per share, or $100 total). Assume that the stock of ABC Company is currently trading at $50. Put contracts with a strike price of $50 are being sold at $3 and have an expiry period of six months. In total, one put costs $300 (since one put represents 100 shares of ABC Company).

The stock price must remain the same or increase above the strike price for the put seller to make a profit. If the ABC company’s stock drops to $80 then you could exercise the option and sell 100 shares at $100 per share resulting in a total profit of $1,500. In a covered call strategy, a trader sells out-of-the-money calls on a stock they own.

The range of strike prices you can choose from is typically determined by the options exchange. A short put, on the other hand, occurs when you write or sell a put option on an asset. Let’s say you believe Company X’s stock, which trades at $98, will drop in the next week to $90 and you decide to make the purchase. If the put option trades at $2, you sell it and net $200, setting at your buying price at $90, provided the stock trades at that price on or before the date of expiration. Yes, a put option allows the contract holder the right, but not the obligation, to sell the underlying asset at a predetermined price by a specific time. However, if you have a short position on the bearish ETF, if the S&P 500 gains 1%, your short position should gain 1% as well.

Writing call options vs. writing put options

Then, if there is a depreciation in the price of the underlying asset, the investor can sell their holdings at the strike price. Put buyers make a profit by essentially holding a short-selling position. If you’re looking to trade options, you can sell them as well as buy them.

Call Options vs. Put Options

If you’re looking for a long-term investment option, stocks are probably the better choice and tend to be a better option for new investors. Options can be more flexible and often come with smaller investment requirements. But the strategies are more complex and are typically better-suited for more skilled investors. The strike price is the price your asset is at when a call or a put option can be exercised.

The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. For example, if the stock is at $90 and the ABC $95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value. In this case, it is better to sell the put rather than exercise it because the additional 50 cents in time value is lost if the contract is closed through exercise. Exercising a put option means the investor is choosing to utilise their right to sell the underlying asset at the predetermined strike price.

Why would you buy an option?

We believe everyone should be able to make financial decisions with confidence. NerdWallet, Inc. is an independent publisher and comparison service, not an investment advisor. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. NerdWallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. Examples are hypothetical, and we encourage you to seek personalized advice from qualified professionals regarding specific investment issues.

Leave a Reply

Your email address will not be published. Required fields are marked *