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Put Options
Put options give the buyer the right, but not the obligation, to sell
an underlying asset at the strike price until their broker’s cut-off
time shortly after market close on the last trading day before expiration.
Just like call options, put options come in various strike prices
depending on the current market price of the underlying instrument as well
as a variety of expiration dates. Expiration dates can vary from one month
out to more than a year (LEAPS options). However, unlike call options, you
might consider going long a put option if you expect market prices to fall
(bearish). In contrast, if you are bullish (expect the market to rise),
you might consider selling a put option.
If you choose to buy or go long a put option, you are purchasing the
right to sell the underlying instrument at the chosen strike price until
expiration. The premium of the long put option will show up as a debit in
your trading account. This value is the maximum loss you risk by
purchasing a put option. The maximum profit is limited to the downside
since the underlying stock can only fall to zero. A profit can be made in
one of two ways as the underlying market declines. If and when the
underlying stock falls below the put strike price, you can exercise the
put to short the shares at a higher price and then immediately buy the
underlying stock at a cheaper price to cover the short and exit the trade
(strike price - current price = profit). The second technique for
profiting on a put comes from offsetting it. If the price of the
underlying stock falls, the corresponding put premium increases and can
then be sold at a profit. If you go long a put option and the underlying
security (index or stock) increases in price, the value of the put will
fall. Then you can either sell the put at a loss or let it expire
worthless.
If you choose to sell or go short a put option, you are obligated to
sell the underlying stock at a particular strike price. The premium of the
short put will show up as a credit in your trading account. In most cases,
you are anticipating that the short put option will simply expire
worthless on the expiration date so that you can keep the premium
received. The premium amount is the maximum profit you can receive by
selling a put option. If the underlying stock falls below the put strike
price, the put will most likely be assigned. The option seller then has an
obligation to buy the underlying stock (usually 100 shares per option) at
the put strike price. You will then be long shares of the underlying stock
and the loss incurred depends on how low the price of the underlying stock
falls as you try to sell the shares to exit the position. Experienced
traders who choose to go short put options do so in a stable or bull
market because the put will not be exercised unless the market falls.
Put options give you the right to sell something at a specific price
for a fixed amount of time. A put option is in-the-money (ITM) when the
strike price is higher than the market price of the underlying asset. A
put option is at-the-money (ATM) when the price of the underlying security
is equal (or close) to its strike price. A put option is out-of-the-money
(OTM) when the price of the underlying security is greater than the strike
price.
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Example: Jane opens a small travel
business that specializes in island vacations. The manager of a a
local business agrees to purchase 100 trips to Hawaii in January for
$300 round-trip as perks for his employees. Jane's computed total
cost of each trip is $200-a $100 profit on each trip which locks in
a guaranteed profit of $10,000 for her initial period of operation.
In effect, the guaranteed order is a put option.
Scenario 1: As luck would have it, just as November rolls
around, a competitor offers the same trip for only $250. If Jane
didn't have a put option agreement, she would have to drop her price
to meet the competition's price, and thereby lose a significant
amount of profit. Luckily, she exercises her right to sell the trips
to Hawaii for $300 each and enjoys a healthy profit in the new year.
Jane's put option was in-the-money in comparison to the price of her
competitor.
Scenario 2: Jane gets a call from another client who needs to
set up 100 trips in January to fulfill obligations to his management
team and is willing to pay up to $400 per trip. Since Jane is under
no obligation to sell the trips to her first customer, she agrees to
sell them for the higher market price and makes a total profit of
$20,000 on the deal. |
Put Option Review
Put options give traders the right, but not the obligation, to sell
the underlying stock at the strike price until their broker’s cut-off
time shortly after market close on the last trading day before
expiration. A put option is in-the-money (ITM) if its strike price is
above the current price of the underlying stock. A put option is
out-of-the-money (OTM) if its strike price is below the current price of
the underlying stock. A put option is at-the-money (ATM) if its strike
price is the same as (or close to) the current price of the underlying
stock.
Buying Puts (long-bearish). The trader believes the market will fall
and buys (go long) puts. When the put is purchased, it is called an
opening transaction. Now, the buyer has rights. A put buyer has the
right, but not the obligation, to sell the underlying stock at the
strike price of the option until the expiration date. Furthermore, if a
trader buys a put option, the risk of the trade equals the money paid
for the option, or the debit. The profit is approximately equal to the
fall in the price of the underlying asset. The potential profit is
limited, but high, because the underlying asset cannot fall below zero.
Finally, to offset a long put, the trader will sell a put with the same
terms (strike price and expiration) to "close" out the
position. On the other hand, if the trader exercises a long put, then he
or she is selling, or short, the underlying stock or index at the strike
price of the put option.
Selling Puts (short-bullish). The trader believes the market will rise
and sells (goes short) puts. Sellers have obligations. A put seller has
the obligation to buy the underlying stock (usually 100 shares per
option) at the put strike price. In other words, the option seller must
be ready to have the stock "put" to him or her. The put
seller's risk is the drop in the stock price, which is limited to the
stock falling to zero. The profit equals the credit received from the
sale of the put. Put sellers often prefer options with little time left
until expiration because they want a put to expire worthless. In that
way, the seller keeps the entire premium. A short put is offset by
purchasing a put with the same strike price and expiration to close out
the position.
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