Put options are the lesser-known cousin of call options, but they can be every bit as profitable and exciting as their more popular relative. Put options allow buyers to magnify the downward movement of stocks, turning a small price decline into a huge gain for the put buyer. Puts are one of the two basic types of vehicles in options trading, along with calls.
This article provides examples of the upsides and downsides of buying and selling puts, and how that compares to short-selling a stock.
# Put options
The basic question in an options trade is this: What will stock be worth at some future date? There are only two answers: more or less.
Buying a put option is a bet on “less.” Selling a put option is a bet on “more.”
A put option is a contract that gives the owner a right, but not the obligation, to sell a stock at a predetermined price (known as the “strike price”) within a certain time period (or “expiration”). The put buyer pays a premium per share to the put seller for that privilege.
Each contract represents 100 shares of the “underlying” stock, or the stock on which the option is based. Investors don’t have to own the underlying stock to buy or sell a put.
At expiration, if the stock price is lower than the strike price, the put is worth money. In this situation, the value of the put equals the strike price minus the stock price times 100, because each contract represents 100 shares.
If the stock price is higher than the strike, the put is worthless.
# Buying a put option
Put options function as a kind of insurance, though investors don’t have to own what’s being insured — the stock — to buy a put. Put buyers generally expect the stock to decline, and a put provides a higher potential profit than short selling the stock.
If the stock declines below the strike price before expiration, the option is considered to be “in the money.” Then the buyer has two choices. First, if she owns the stock, she can exercise the contract, putting the stock to the put seller at the strike price, effectively selling the stock at an above-market price and realizing the profit. Second, the buyer can sell the put before expiration in order to capture the value, without having to sell any underlying stock.
If the stock stays at the strike price or above it, the put is “out of the money” and the buyer loses her entire investment.
Here’s an example. XYZ is trading for $50 a share. Puts with a strike price of $50 are available for $5 per contract and expire in six months. In total, one put costs $500 (1 put x $5 x 100 shares).
The graph below shows the buyer’s profit on the put at expiration when the stock is at different prices.
Because one contract represents 100 shares, for every $1 decrease in the stock below the strike price, the total value of the option increases by $100.
The breakeven point — below which the option begins to earn a profit — occurs at $45. That is the strike price minus the cost of the put ($5 per share). If the stock is between $45 and $50 at expiration, the option will retain some value, but will not show a profit. Conversely, if the stock remains above the strike price of $50, the option becomes worthless. So the option value flatlines, capping the investor’s loss at the price paid for the put, of $5 per share or $500 total.
# Selling a put option
In contrast to put buyers, put sellers have an obligation to buy the underlying stock at the strike price until expiration. The put seller must have either enough cash in the account or margin capacity to buy the stock from the put buyer. However, the put option typically will not be exercised unless the stock price is below the strike price; that is, unless the option is in the money. Put sellers generally expect the underlying stock to remain flat or move higher.
If the stock declines below the strike price before expiration, the option is in the money. The seller will be put the stock and must buy it at the strike price.
If the stock stays at the strike price or above it, the put is out of the money, and the put seller keeps the premium and can sell puts again.
Here’s an example. XYZ is trading for $50 a share. Puts with a strike price of $50 can be sold for $5 per contract and expire in six months. In total, one put sells for $500 (1 put x $5 x 100 shares).
The graph below shows the seller’s profit on the put at expiration when the stock is at different prices.
Each contract represents 100 shares, so for every $1 decrease in the stock below the strike price, the option’s cost to the seller increases by $100. The breakeven point occurs at $45 per share, or the strike price minus the premium received. The put seller’s maximum profit is capped at $5 per share, or $500 total. If the stock remains above $50 per share, the put seller keeps the entire premium. The option continues to cost the put seller money as the stock declines in value.
# Puts vs. short selling
Buying put options can be attractive if you think a stock is poised to decline, and it’s one of two main ways to wager against a stock. The other is short selling. To “short” a stock, investors borrow the stock from their broker, sell it in the market, and then buy it back if and when the stock price declines. The difference in sell and buy prices is their profit. Puts can pay out much more than shorting a stock, and that’s the attraction for put buyers.
Here’s an example to compare the three strategies. XYZ stock is trading at $50 per share, and for $5 per contract, an investor can purchase a put with a $50 strike price expiring in six months. The investor has $500, allowing her to short 10 shares of XYZ or buy one put contract. Each options contract represents 100 shares, so 1 contract x $5 x 100 = $500.
Here’s the payoff profile at expiration for short-sellers, put buyers and put sellers.
|Price movement||Short-seller’s profit/loss||Put buyer’s profit/loss||Put seller’s profit/loss|
|Assumes no transaction fees|
There’s a reason why put buyers get excited. If the stock moves down 40% and earns $200, then the options magnify that to a $1,500 gain for the put owner. Buying puts offers better profit potential than short selling if the stock declines substantially. The put buyer’s entire investment can be lost if the stock doesn’t decline below the strike by expiration, but the loss is capped at the initial investment. In this example, the put buyer never loses more than $500.
In contrast, short selling offers less profitability if the stock declines, but the trade becomes profitable as soon as the stock moves lower. At $45, the trade has already made a profit, while the put buyer has just broken even. The biggest advantage for short-sellers, though, is that they have a longer time horizon for the stock to decline. While options eventually expire, a short-seller need not close a short-sold position, as long as the brokerage account has enough capital to maintain it.
The most significant downside to short selling is that losses can be theoretically infinite if the stock continues to climb. While no stocks have soared to infinity yet, short-sellers could lose more money than they put into their initial position. If the stock price continued to rise, the short-seller might have to put up additional capital in order to maintain the position.
Meanwhile, a put seller has limited upside and significant downside. The maximum that the put seller can receive is the premium — $500 — but he has to be able to buy 100 shares of stock at the strike price if the stock is put to him. Potential losses could exceed any initial investment and might amount to as much as the entire value of the stock, if the underlying stock price went to $0. In this example, the put seller could lose as much as $5,000 if the underlying stock went to $0 (as seen in the graph).
Put options remain popular because they offer more choices on how to invest. They allow investors to:
Limit risk-taking while generating a capital gain. Put options can be used to limit risk. For example, an investor looking to profit from the decline of XYZ stock could buy just one put contract and limit the total downside to $500, whereas a short-seller faces an unlimited downside if the stock moves higher. Both strategies have a similar payoff, but the put position limits potential losses.
Generate income from the premium. Investors can sell options to generate income, and it’s a reasonable strategy in moderation. Even on low-volatility, high-quality stocks, investors could see annualized returns in the low teens. That’s tempting, especially in a rising market, where the stock is not likely to be put to the seller.
Realize more attractive buy prices. Investors use put options to achieve better buy prices on their stocks. They can sell puts on a stock that they’d like to own but that is too expensive currently. If the price falls below the put’s strike, then they can buy the stock and take the premium as a discount on their purchase. If the stock remains above the strike, they can keep the premium and try the strategy again.
Originally posted at NerdWallet.