Understanding Puts
On our "What are Options?" page we discussed the basics of the basics regarding options. We discussed what options are, and how they can be used, and we also provided an example.
For Understanding Puts we want to provide a little more detail about Put options, and also provide examples that will help you grasp the concepts better. Remember there are two types of options, a "call" option and a "put" option. An investor or trader can go long (or buy) a call or a put. And they can also short (sell) a call or a put. Whether an investor buys or sells a call or a put depends on the investors intentions and expectation of the underlying investment instrument.
We will continue using the example from the What are Options? page, PEAR Jan 18 2019 $100. Our hypothetical company Pear (PEAR) is our underlying investment instrument.
Put Options
An investor can buy or sell a put option depending on the investors outlook on the underlying investment instrument. If an investor believes a stock will increase in price, the investor would sell a put option of the underlying stock. If the investor believes a stock will decrease in price, the investor would buy a put option of the underlying stock. Using the Pear Put Option below, lets discuss the roles of the Put option buyer and seller.
Put Buyer
As the buyer of a Put option, an investor has the right, but not the obligation to sell a security or financial asset at the strike price. As a buyer of the put option above, an investor would purchase the option for $5.75, this is known as the premium. When the buyer purchases the option they are buying to open, meaning they are opening a contact with the seller of the option. In this case the buyer of the PEAR Jan 18 2019 $100 Put option is anticipating that Pear's stock will trade below $100 per share before January 18. 2019. The buyer of a put option profits when the underlying stock or financial instrument decreases. For an example let's imagine that PEAR's stock trades at $75 per share before the January 18 2019 expiration date, the put option buyer can enter the market, buy PEAR stock for $75 per share, and sell it to the put option writer (seller) for $100, making a $2,500 profit ($100 - $75 = $25 x 100), commissions and transaction fees not included. Let's take a look at a few different scenarios that a put option buyer may face.
Scenario 1: Pear's stock is trading at $125 per share.
The buyer of the put option in this example is out-of-the-money, since the stock price is above the strike price. The put option buyer can enter the market and sell the put option to close the contract if the put option has any value, or the put option buyer can let the option expire worthless.
Scenario 2: Pear's stock is trading at $75 per share
As we stated earlier, in this scenario the put option is in-the-money. The put option buyer can enter the market and buy PEAR shares for $75, and sell them to the put options writer/seller for $100 per share (the strike price).
Scenario 3: Pear's stock is trading at $75 per share, and the option is trading at $9.25 | $9.75.
For the put option buyer when the stock or financial instrument goes down the value of the option goes up. In this scenario the stock price is below the strike price, therefore the premium of the option has increased. The buyer of the put option can sell the put option in the market for a higher premium than they paid for the option. The buyer of the put option would sell the option at $9.25, making a $3.50 profit or $350 ($9.25 - $5.75 = $3.50 x 100 = $350).
Scenario 4: Pear's stock is trading at $100 per share
In the scenario the option is at-the-money. The put option buyer could sell the option to close the contract if the option has any value or let the option expire worthless.
Purchasing put options is a substitute for shorting stocks and it carries less risk than outright short selling a stock. Using an example similar to Scenario 1 to illustrate our point. Let's say PEAR's stock goes to $200 per share prior the expiration date of the option. A put buyer's option would lose value and expire worthless. The most the put option buyer could lose is the $575 he/she paid for the option (5.75 x 100 = $575). Now let's say instead of buying a put option, our investor sold short 100 shares of Pear at $100, our investor would be out $10,000. (the short seller must purchase 100 shares of the stock at the current market price - $200 per share - and sell it to the investor on the other side of the short sale for $100) -$200 + 100 = -$100 x 100 = -$10,000). In the real world we would hope that a person that sold short a stock at $100 per share doesn't wait until $200 share to cover their short.
Put Seller or Writer
A seller of a put option is obligated to buy the underlying security at the strike price from the put option buyer if the option is exercised. A seller or writer of a put option is hoping the underlying security or investment instrument increases in price or stays "at-the-money." Using our option example above, the call writer would receive $5.75 for each PEAR Jan 18 2018 $100 Put they sold. However if the stock trades below $100 per share, the put option writer is obligated to purchase PEAR at $100 from the put buyer if the option is exercised thus losing the premium received ($5.75) and the additional monies used to purchase PEAR at $100 per share.
Let's go through the scenarios as a put option writer.
Scenario 1 Pear's stock is trading at $125 per share.
In this scenario the put writer is in the money. The buyer of the put will either sell to close their position or let the option expire worthless. The put writer keeps the $5.75 received from selling the put.
Scenario 2 Pear's stock is trading at $75 per share.
In this scenario the put writer is out of the money. If the put buyer exercises the option, the put writer is obligated to purchase 100 shares per option contract from the put option buyer at $100 per share or the strike price. The options buyer will pay $100 per share for a stock trading at $75 per share incurring a $25 per share loss or a total loss of $2,500.
Scenario 3 Pear's stock is trading at $100
This put option would be considered to be "at-the-money" since the underlying stock is trading at the same price as the strike price. The put option buyer will likely let the option expire worthless, and the put option writer can keep the $5.75 premium received for the option
Writing Put Options
Writing put options can be risky, but the risk is capped. The writer of a put options max loss is the strike price minus the premium received if the stock goes to zero. Using our PEAR Jan 18 2019 $100 Put option example, the max a put options writer could lose is $9,425 per put option contract sold if the stock went to zero. (-$100 + $5.75 premium received = - $94.25 x 100 = - $9,425). In the real world it's rare that an investor will let the stock hit zero, the investor will likely close their position to minimize their losses.
We hope that this gives you a better understanding of put options. Keep an eye out for more articles coming to our Beginners Block. Get notified about our new articles, reports, and research by leaving us your email. If you have a question for us please email us here.
