Put Options: What, Why, And When?

This might not mean anything to you right now, sounding a bit like two words that accidentally met at a bar and combined to form an odd couple whom you have no idea how they work or what they do.

Fear not: this article lays it out in the simplest terms for you.

What it means

In the simplest possible terms, a put option is an agreement that the buyer may sell some amount of security back to its buyer at a fixed price.

The aim is to make a profit.

The agreement that the purchaser (holder, in investment terminology) may sell some of the security back is not a binding one. 

In other ones, they are not compelled to sell it back to the original owner (or writer, in investment terminology), but may choose to do so.

It is a voluntary sell-back scheme.

Put options have both quantity, a specific price, and a time limit or requirement embedded in them.

• So, the buyer may sell back a certain amount as part of the put option, not the entire value of the security.
• The put option has a specified price, meaning that you sell at that price only (a strike price, as is called in the industry).
• There is a date of expiration for the put option, after which the original seller will not be forced to buyback the amount of security (should the buyer wish to do so).

When it comes to stock options, the put option or contract (some prefer to use this term) covers no more than 100 shares.

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Buying a put option: why and when?

An options trader, for example, could purchase put options if they wish to profit from a fall in an asset’s price.

As the price falls, the buyer can obtain the shares at the market price but sell them for the strike price, a pre-agreed price.

If this is higher than the market price, the trader makes a profit.

Let’s look at an example

Our company in question is called Johnny’s Jam Inc.

It currently trades at $40 a share on the market.

Steve buys a put option contract with a strike price of $40 expiring in one month.

The price is $2 per share, covering 100 shares.

He is doing this because he reckons that market forces and an increase in health fears about the fattening effects of jam-based products will cause Johnny’s Jam Inc. to lose value.

A few weeks later (but before the month is up) he is proved right, and JJ Inc. is now trading at $30 a share, a loss of $10 or 25%.

Activating their right to sell under the put option, Steve makes a healthy profit of $800.

How did we get that number?

By activating his agreed right to sell, he essentially says ‘it doesn’t matter that the market price is $30 a share, I agreed that I could sell them at $40.’

And he does just that.

He doesn’t even need to own any stock at that point.

He simply goes onto the stock market, buys 100 shares at $30 each like any other trader, and then sells them immediately for $40 a share.

Do this with 100 shares and he makes $1000, or $10 profit per share: minus the original price of the put option, $200, and he has earnings of $800.

Not bad.

The earnings potential is illustrated by the graph below.

See how the lower the price of the stock is, the more profit he makes (the higher the difference between the strike price and the market price).

This is what investors call a long put strategy.

It is essentially a bet on a fall in the stock price.

The buyer of the put option is the person placing the bet, and the seller and stockholder is the bookie.

Types of put options: the protective put

This type of put is used by an investor who is aiming to protect their long stock position.

Index puts are used to cover entire portfolios of stock options.

Selling put options

You might ask yourself why on earth anyone would undertake the role of the seller or writer of put options, based on the example you just saw.

Seems like a great way to lose money?

Well, as with any bet, there is significant risk involved.

The point is to see it as an opportunity to make money too.

Write the option, wait for the market to maintain and the price to stay constant, then pocket the premium paid ($2 a share in the case of our example) once it expires.

There is perhaps more risk, but if correctly done, the process can be profitable.

A covered put

This is when a seller writes a put option like the one we have shown, but then short sells (sells stock that they do not own themselves) to cover the put option.

This is essentially a balancing act.

• If the stock price stays the same, his short sell makes no loss or gain, and he keeps the $200 gained from the put option as profit
• If the stock price falls, he will lose on the put option but hopefully, make it back on the short sell’s gain
• However, if the stock rallies, the short sell backfires, and the investor loses money, minus the $200 put option

As you can see, it risks a big loss but can be clever if the market goes the investor’s way.

The naked put: cheeky!

A put option is naked if the writer, or seller, did not do the above and short the obligated quantity of the stock.

This is done if the trader is confident on the stock performing well.

Spread those puts baby: put spreads

As the name suggests, it is a tactic whereby you spread the risk of the put option over multiple different ones.

Multiple options are bought and sold on the same security, with a variety of prices and time frames.

This works by the put options interacting and balancing out against each other, minimizing the maximum loss or profit from the exercise, and thus, the risk.