Put Option Explained

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How a Put Option Trade Works

Put options are bets that the price of the underlying asset is going to fall. Puts are excellent trading instruments when you’re trying to guard against losses in stock, futures contracts, or commodities that you already own.

Here is a typical situation where buying a put option can be beneficial: Say, for example, that you bought XYZ at $31, but you start getting concerned, because the stock price is starting to drift down because the market is weakening.

A good way to protect yourself when you’re in this situation is to buy a put option. So you decide to buy an August 30 put for a $1 premium, which costs you $100.

By buying the put, you’re locking in the value of your stock at $30 per share until the expiration date on the third Friday in August. If the stock price falls to $20 per share, you still can sell it to someone at $30 per share, as long as the option has not expired. Indeed, the put option gives you the right to sell the stock at $30 no matter how low the price falls.

Using the put option as portfolio insurance fixes your worst risk at $200, which includes the $100 premium you paid for the put option and the $1 per share you can lose after originally paying $31 per share for the stock, if you exercise the put.

Your other alternative when the stock falls below $30 is to sell the put to the market and profit from the appreciation of the option while holding onto the stock.

Difference Between Call and Put Option

Last updated on May 19, 2020 by Surbhi S

The market is flooded with an array of investment options that allows the investors to earn money, when the stock market is rising or falling or going sideways. Options are one of the significant categories of derivative securities, which connotes a contract between parties, in which one party acquires right to trade the underlying security, at an agreed price, on or before a particular date. The right to buy is call option while when the right relates to selling, it is a put option.

Calls allow you to make money when the value of financial products is going up. On the other end, puts will reap money when the stock price of the underlying asset are going down. Just take a glance at this article to know more distinguishing points between the two.

Content: Call Option Vs Put Option

Comparison Chart

Basis for Comparison Call Option Put Option
Meaning Call option grants right to the buyer, not the obligation, to buy the underlying asset by a particular date for the strike price. Put option grants the right to the buyer, not the obligation, to sell the underlying asset by a particular date at the strike price.
What it allows? Buying of stock Selling of stock
Relationship with stock market Direct Inverse
Potential gain Unlimited Limited
Investor looks for Price Rise Fall in prices

Definition of Call Option

A derivative contract between buyer and seller in which the buyer is offered the right to buy the underlying asset, by a certain date at the strike price. When you purchase a call option, you purchase the right to purchase the financial product on or before a specific date in the future, at a fixed price. For this, you need to pay an upfront cost in the form of premium.

When the buyer exercises his option to buy the stock from call option, the seller is obligated to sell the stock, at the price agreed by the parties earlier. All the stock market instruments are covered in the call option such as stock, bond, currency, commodities and much more.

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Definition of Put Option

A put option is defined as an option contract between two parties, buyer and seller, whereby buyer has the right to sell the underlying asset, by a certain date at the strike price. The buyer of the option must pay the premium to earn such right. When you purchase a put option, you earn the right to sell the stocks, on or before a certain future date, at a set price.

Once the buyer exercises his right option to sell the underlying asset, the seller has no choice other than buying the asset at the agreed price. So, the seller is obligated to purchase the financial instrument. In other words, the reverse of a call option is a put option.

Key Differences Between Call and Put Option

The major differences between call and put option are indicated below in the following points:

  1. The right in the hands of buyers to buy the underlying security by a particular date for the strike price, but he is not obligated to do so, is known as Call option. The right in the hands of the buyer to sell the underlying security by a particular date for the strike price, but he is not obligated to do so, is known as Put option.
  2. A call option allows buying option, whereas Put option allows selling option.
  3. The call generates money when the value of the underlying asset goes up while Put makes money when the value of securities is falling.
  4. The potential gain in case of a call option is unlimited, but such gain is limited in the put option.
  5. In the call option, the investor looks for the rise in prices of the security. Conversely, in the put option the investor expects stock prices to go down.

Similarities

Some similar aspects are there in the two investments like both acts as an agreement between the buyer and seller in the financial market, where time works as an essence of the contract, i.e. the option needs to be exercised before the time expires. Moreover, the losses in both the cases are limited to the amount paid on premium.

Examples

Call Option

Suppose A (buyer) purchases a call option and enters into a contract with B (seller) that A will purchase 1000 shares at Rs. 200 per share of Alpha Ltd. after three months, and pays a premium of Rs. 5000 for the same. If after three months the prices of the shares are Rs. 220 then A can purchase shares from B at Rs. 200 by exercising the right and B is obligated to pay the same while if the prices go down to 180 then A will not purchase the same from B because he can purchase the same from any other person at Rs. 180 from any other person in the market.

Put Option

Suppose A (buyer) purchases a put option and enters into a contract with B (seller) of selling 1000 shares of Rs. 200 per share of Alpha Ltd. (present prevailing price in the market) after three months from the date. A pays a premium for it, of Rs. 5000. Before the expiry of the term, the price of the company falls to Rs. 180 per share, then A can purchase the shares from the stock market at Rs. 180 per share and sell them to B at Rs. 200 per share. However, if the share price increases to Rs. 220, then there is no use of purchasing it on high rate at selling it at a low rate because that will ultimately amount to a loss for A.

Conclusion

When you invest in a call option, you always expect the price to rise to reap more and more profits, whereas if you opt for a put option you want the prices to fall because only then you will be able to earn profits or else you will suffer loss up to the extent of the premium paid. Call option and put option are the two exact opposite terms.

Long Put Option Overview

Kevin Ott

The long put option strategy is a bearish options trading strategy that capitalizes on increases in volatility and downward moves in the underlying asset. In addition to speculation, purchasing put options are a common way to hedge existing long positions from drastic declines.

Contrary to many long option trading strategies, the long put option strategy has a limited profit, which is capped at the underlying asset going to zero. Long call options, however, have a theoretical unlimited profit. Read more about puts.

Key Points

  • Long puts perform very well in bear markets when volatility expands and underlying prices decline
  • Long puts decay over time
  • Traders commonly purchase puts as a hedge against their long stock positions
  • Ally Invest is the best & cheapest online broker to trade long puts
  • Ally charges only $0.50 per contract

Tastyworks is one of the most popular online brokerages to trade put options because of $0.00 commissions and free professional options trading platforms.

Long Put Option Strategy Definition

Note: like most options strategies, you can buy puts in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). Unlike buying calls, the potential profit for buying puts is not unlimited, since assets can’t trade below zero.

Long Put Option Strategy Example

Stock XYZ is trading at $50 a share.

Buy $47 put for $0.30

Long Put Summary

Maximum Profit Defined
Maximum Loss Defined
Risk Level Medium
Best For Making large sums of money when prices plummet
When to Trade When you expect a stock to crash
Legs 1 leg
Construction long out
Opposite Position Short put

Maximum Profit and Loss of the Long Put Option Strategy

Maximum profit for a long put = UNDERLYING ASSET GOING TO ZERO

Maximum loss for a long put = PREMIUM SPENT

Break-Even for the Long Put Option Strategy

Breakeven point for the long put option strategy = strike price – premium spent.

In the example above, the break-even point at expiration for buying 1 put in stock XYZ is $46.70 (strike price of option [$47] – premium spent [$0.30]).

In other words, stock XYZ has to fall $3.30 in order to break even by the time the put expires.

Why Trade Long Put Options?

The main reason to buy puts in an underlying asset is out of fear or speculation that the underlying asset is going to decrease in value. A long put only pays if the underlying asset depreciates. Unlike many other options strategies that pay if nothing happens, oftentimes dramatic moves are required for the long put option strategy to be profitable.

Besides buying puts to hedge long positions or entire portfolios, traders often buy puts to synthetically short a security without the possibility of an unlimited loss.

When selling a stock or future short, i.e. selling to open, the max loss is theoretically unlimited. However, the max loss for a long put is always the total sum of the premium spent. This makes buying puts an attractive option for short-biased traders looking to limit their upside risk.

The Hidden Risk of Buying Puts

Traders should be aware that puts generally trade more expensive than calls.

For the majority of securities, there is always a possibility (however faint it may be) that the security could completely crash down. This is because there is an emotional element to a stock or futures contract or index that’s crashing and burning. Many traders just want to get out of a falling stock, but when this happens, the selling only increases.

Buying puts should be thought of as buying insurance in case the underlying asset crashes. A lot of hedge funds and institutions can only maintain so much long exposure in the market, and instead of trimming their positions, they will often buy puts to protect their downside exposure; this also creates a demand for puts and it just makes them more expensive. The downside risk is simply larger for most people than the upside risk, because most market participants are long. The giant exception to this is with individual stocks, particularly biopharmaceutical stocks, where it’s common to see 300% increases overnight following a favorable FDA result. Before and after events like this, calls can totally trade richer than puts.

The hidden risk with buying puts is overpaying for protection that will only pay if there is a severe drop in the underlying asset, like 20%. Stock crashes and financial crises are pretty rare, but they do happen. Nevertheless, put buyers need to be aware that far OTM puts can trade very rich with implied volatility, yet they have a high likelihood of ultimately expiring worthless.

Why Not Just Sell Puts If They All Expire Worthless?

Well, all puts do NOT expire worthless. Puts that are ATM frequently expire ITM. For far out-of-the-money puts, the likelihood of a worthless expiration is heightened. However, the massive caveat is that just because the puts will end up expiring worthless does not mean that they won’t increase in value before expiration.

Even far OTM puts can double or triple in value with spikes in volatility, and this instills enough fear to cause many put writers to close out their positions; or be obligated to because of margin calls.

Margin Requirements for Long Puts

The margin requirement to buy a put is always the total cost of the premium, i.e. the margin requirement for a long put is the maximum loss for the trade.

What About Theta (Time) Decay?

Theta decay hurts a long put that is ATM or OTM. If you are long an OTM put, you will be fighting premium decay everyday. This is one of the major reasons why making money with puts that are OTM is so difficult.

When should I close Out a Long Put?

It depends on your objective. If you bought the put to hedge, then it would obviously be unwise to close the hedge prior to closing the original investment that necessitated a hedge. Ideally, the hedge and the original investment should be closed out at the same time to avoid slippage.

A lot of traders who purchase puts out of speculation close out the put prior to expiration. As expiration nears, volatility and time premium will have less of an effect on an option’s price.

As a general rule, long puts that have decreased to a near zero value should never be closed out. Essentially, it is a riskless trade. The value of the put can’t go below zero, so it can only go up in the event volatility increases or the underlying asset decreases.

Anything I should Know About Expiration?

If a long put expires out-of-the-money, there is no need to take action. The position will automatically fall off of your account by the next trading day.

If a long put expires in-the-money, there might be some cause for concern. If you do not have enough capital in your account to short the appropriate number of shares, a margin call will likely be issued. Usually, your broker will contact you prior to expiration asking you to close out a long put position that would have a negative margin impact on your account.

The other expiration risk with owning puts, assuming the underlying asset is a stock, is that there will not be a lot of available stock to borrow. If this is the case, you could end up being short the stock and charged a hard-to-borrow fee. However, this is very rare and it is best to check with your broker prior to expiration about the impact of a long put.

Important Tips on Buying Puts

The long put option strategy is a great way to short an asset and eliminate the possibility of an unlimited loss. If you sell a stock or futures contract short, there is always the possibility of the worst-case scenario loss. The long put option trading strategy eliminates this possibility. In exchange for this favorable risk/reward ratio, long puts (especially those that are OTM) have a high probability of expiring totally worthless. If you short a stock or future, the short position itself can never be worthless.

This is one of the key distinctions between buying puts and outright shorting an asset. Another key distinction, is that puts are subject to changes in volatility, where shorting an individual asset is not.

Meaning, if an asset crashed, a long put position would benefit from an explosion in volatility as well as, obviously, a decline in the underlying asset. This is one of the reasons why traders like buying puts, because the added component of volatility almost adds another way to make money.
Tastyworks is one of the most popular online brokerages to trade put options because of $0.00 commissions and free professional options trading platforms.

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