What is a put option?
A put option conveys the right to sell stock at a fixed price (the “strike price”) on or before the expiry of the option. If you are a buyer (taker) of a put option, you can exercise your right to sell stock when the market gets to or below your strike price. That means you are selling the stock for a higher price than its current market price. The writer (seller) is obliged to buy your stock at the strike price. Instead of exercising the option it can also be sold back to the market, or in other words, it can be “traded”. (See “How to trade options“.)
Please note that we have chosen “stock options” for the sake of the explanation below. (See “What are stock options“.)
When do you buy a put option?
You may decide to buy a put option when you expect the share price to fall. You would pick a strike price just below but close to the current share price, and you pay a premium to the writer of the option to receive the right to sell your shares at that strike price.
If you are right and the share price did drop this means you can sell your shares for more than their current market price. But maybe you didn’t really own shares in the first place (you don’t have to in order to buy options!). Maybe you were simply planning to sell the option back to the market for a profit.
If you were wrong and the share price did not fall or it even rose, you would not exercise your option. (you wouldn’t sell shares for less than their current market value!) The option would lose in value, but you could still recover some of your initial outlay by selling it back to the market. if you let the option expire without doing anything, you have lost the premium you paid initially. That’s your maximum possible loss.
When do you sell a put option?
You may decide to sell a put option if you have the view that the market will remain steady or rise. You generate your income at the point where you sell the put (you receive the premium paid by the buyer), and you want the stock price to remain above the strike price until the option is expired. That way you get to keep your premium (your profit).
If you are right and the stock price remains steady or rises, the taker of the option will not want to exercise it, and if no one exercises the option before it expires, you as the writer get to keep the full premium initially paid by the buyer.
If you were wrong and the stock price falls below the strike price, the buyer would be able to exercise the option at expiry and you would have to buy the underlying stock off him for a much higher price than this stock is worth. Alternatively you act before the expiry date and buy the option back for its – now much higher – market price. Writing put options without further protective measures is also called writing them “naked”. You should never write naked options!
Options trading strategies
Options can be combined to exploit every possible market setup. For example if you sold a put over a certain stock with a certain strike price, and also bought a put over the same stock with a different strike price (but the same expiration) this would be called a “spread trade”. Options are generally combined to form options trading strategies in order to limit your possible losses. Please make sure you order our Free Options Trading CD which has a very detailed section on bull call spreads and bull put spreads, including recordings and many other topics!