Understanding what is put option: its strategies, risks, and how they work in trading
Put options are one of the most commonly traded financial instruments in modern investing. These financial derivatives grant the holder the right to sell an underlying asset at a specific price, known as the strike price, within a designated period. Investors and traders often use them for hedging purposes, to protect their portfolios from potential losses or to speculate on price declines.
For many investors, understanding how put options function is essential for managing risks effectively and taking advantage of market opportunities. Put options are versatile instruments offering substantial rewards with limited risk, making them a crucial component of many investment strategies. This article will explore what a put option is, how it works, and its various applications in trading and investing.
What is meant by put options?
A put option is a contract in which the buyer gains the right, but not the obligation, to sell a specific underlying asset at a predetermined price, known as the strike price, before or on the option’s expiration date. In essence, the buyer of a put option is purchasing the right to sell the asset at the agreed-upon price, irrespective of the asset’s current market value. If the market price falls below the strike price, the buyer stands to make a profit by exercising the option.
In contrast, the seller of the put option (also known as the writer) must buy the underlying asset at the strike price if the buyer chooses to exercise the option. As compensation for taking on this risk, the seller receives a premium from the buyer at the outset of the contract.
Put options are typically used in various financial markets, including stocks, commodities, and currencies, and they play a crucial role in a wide range of investment strategies.
How do put options work?
Options work based on the movement of the underlying asset’s price relative to the strike price. A put option’s value increases as the underlying asset’s price decreases. This makes put options highly effective for hedging against falling market prices or speculating on future price declines.
For example, an investor who owns shares in a company might buy a put option to protect against potential losses if the share price declines. This strategy allows the investor to sell the shares at the strike price, even if the market price drops below that level. Alternatively, a trader might buy a put option on a stock they do not own if they anticipate that its price will decline. If the stock does fall, the trader can exercise the option and sell the shares at a higher price than the market value, potentially making a profit.
Suppose an investor buys a put option for 100 shares of Company XYZ, with a strike price of £50, and pays a premium of £2 per share. If the stock price of XYZ drops to £40, the investor can exercise the option and sell the 100 shares at £50, even though the market value is £40. After considering the premium paid (£2 per share), the investor’s profit would be £8. However, if the stock price rises above £50, the option expires worthless, and the investor loses the premium paid for the option.
Buying put options
Hedging with put options
Hedging is one of the most common uses for put options. An investor may hold an extensive portfolio of stocks and is concerned about a possible decline in the market. In this case, the investor might purchase options on specific stocks, or an index as insurance. By doing so, the investor can limit their potential losses, as they can sell their stocks at the agreed-upon strike price, regardless of how far the market price falls.
For instance, suppose an investor holds a portfolio of stocks in a specific company and is worried about a short-term decline in the market. The investor could buy a put option with a strike price above the market price. If the stock price drops, the investor can still sell at the strike price, offsetting the losses they incur from the market decline. This type of risk management strategy is often called “protective puts.”
Speculating with put options
Put options are also popular among speculators who believe an asset’s price will fall. By purchasing a put option, a trader can profit from the decline in the asset’s cost, without short-selling the asset itself. This is particularly attractive in markets where short-selling is either difficult or expensive.
For example, a trader might purchase a put option on a stock they believe is overvalued and due for a price drop. If their prediction proves correct and the stock price falls, the trader can exercise the option and sell the stock at the higher strike price, realising a profit. If the stock price does not decline, the trader’s loss is limited to the premium paid for the option.
Selling (Writing) put options
Income generation
The primary motivation for writing put options is to earn the premium that the buyer pays to purchase the option. This strategy is beautiful in stable or bullish markets, where the writer believes the underlying asset’s price will not fall below the strike price. In such cases, the option will likely expire worthless, allowing the writer to keep the premium as profit.
For example, suppose an investor writes a put option for 100 shares of a stock with a strike price of £50 and receives a premium of £3 per share. If the stock price remains above £50, the option expires worthless, and the writer keeps the £300 premium.
Risks of selling put options
While writing put options can be profitable, it carries a significant risk if the underlying asset’s price falls below the strike price. In this case, the writer must buy the asset at the strike price, even though the market price is lower. The writer could face substantial losses if the asset’s price falls substantially. The risk is particularly severe when the underlying asset’s price drops sharply, as there is no limit to how much the writer could lose.
For instance, if the stock price drops to £30, the writer will be forced to buy the stock at £50, incurring a loss of £20 per share (minus the premium received). Therefore, writing put options requires careful consideration of the potential risks and a solid understanding of the market conditions.
Comparing puts and calls
Put options are often compared to call options, as both are financial derivatives. However, they serve different purposes and have distinct characteristics.
Call options
A call option gives the holder the right to buy an underlying asset at a specified strike price within a certain period. Call options are typically used when the investor expects the asset price to rise. If the cost of the asset increases above the strike price, the buyer can exercise the option and buy the asset at a lower price, realising a profit.
Key differences
- A put option gives the right to sell the asset, while a call option gives the right to buy.
- Put options profit from declining prices, while call options profit from rising prices.
- Put buyers expect the underlying asset’s price to fall, whereas call buyers expect the price to rise.
These differences lead to distinct uses for each type of option. Investors may choose to use calls when they are optimistic about an asset’s future price, and puts when they expect a decline.
Strategic uses of put options
Put options can be used in various strategies, both for hedging and speculation, depending on the investor’s goals. These strategies include protective puts, naked puts, and put spreads.
Protective puts
As discussed earlier, protective puts are used as insurance to protect an existing position from downside risk. By purchasing a put option, the investor is guaranteed the ability to sell the underlying asset at the strike price, limiting potential losses if the asset’s price declines.
Naked puts
A naked put is a strategy where an investor sells a put option without owning the underlying asset. This strategy generates income from the premium received but carries significant risk if the asset price falls below the strike price.
Put spreads
A put spread involves buying and selling options with different strike prices but the same expiration date. This strategy limits both the potential profit and loss. It is typically used when an investor believes that the underlying asset’s price will fall, but not significantly.
Factors affecting put option pricing
The price of a put option is influenced by several factors that impact its value. These include intrinsic value, time value, volatility, and interest rates. Understanding these factors is crucial for determining whether a put option is worth purchasing and how its value may change over time.
Intrinsic value
The intrinsic value of a put option is the amount by which the option is “in the money,” meaning the strike price is higher than the current market price of the underlying asset. If the stock price is below the strike price, the option has intrinsic value and is considered in-the-money.
For example, if an investor holds a put option with a strike price of £50, and the current stock price is £40, the option’s intrinsic value is £10 per share. The option has no intrinsic value if the stock price is above the strike price.
Time value
Time value is the portion of the option’s premium that reflects the time remaining until expiration. The longer the time until expiration, the higher the time value, as there is more potential for the underlying asset’s price to move in the buyer’s favour.
As expiration approaches, time value decreases, a phenomenon known as “time decay.” This means that options lose value over time, which can be particularly important for buyers looking for significant price movements within a limited time frame.
Risks of trading put options
Like any investment or trading strategy, trading put options carries risks that investors must be aware of before entering into contracts. Understanding these risks can help investors make informed decisions and manage their portfolios effectively.
For buyers of put options
For the buyer of a put option, the primary risk is limited to the premium paid. If the underlying asset’s market price does not fall below the strike price by the expiration date, the option expires worthless, and the buyer loses the entire premium paid.
This limited risk can be appealing, especially compared to other forms of speculation, such as short selling, where the potential losses are theoretically unlimited. However, the buyer’s loss is confined to the premium, making buying put options an attractive strategy for investors seeking to hedge against downturns or speculate on price declines.
For sellers (Writers) of put options
On the other hand, the seller or writer of a put option faces significant risks. If the underlying asset’s price falls below the strike price, the seller must purchase the asset at the strike price, potentially incurring substantial losses. Unlike the buyer, who can only lose the premium paid, the seller’s losses can be significant, mainly if the asset’s price falls dramatically.
For example, if the stock price drops from £50 to £30, and the seller wrote a put option with a £50 strike price, the seller would be forced to buy the stock at £50, incurring a loss of £20 per share, minus the premium received. Therefore, writing put options requires a clear understanding of the market and the potential for significant losses, especially when writing naked puts (i.e., selling puts without having the capital to purchase the underlying asset).
Mitigating risks
To mitigate the risks associated with put options, many investors use strategies such as spreads, combining buying and selling put options with different strike prices. This helps limit potential gains and losses, providing a more controlled risk-reward scenario. Additionally, having a solid understanding of the asset being traded and its market conditions can help manage risk effectively.
Real-world examples of put options
To better understand how put options work in practice, let’s look at some real-world examples that illustrate how buying and writing put options can be used in different market conditions.
Example 1: Buying a put option for hedging
Imagine an investor, Sarah, who owns 100 shares of a company, XYZ, currently trading at £100 per share. Sarah is concerned about a potential decline in the stock price over the next few months but does not want to sell her shares just yet. To protect her investment, she buys a put option with a strike price of £95 and a premium of £5 per share.
If the stock price drops to £80, Sarah can exercise the put option and sell her shares at £95, even though the market price is £80. Her total profit from exercising the choice would be £95 per share, while she only paid £5 in premium, limiting her downside risk.
On the other hand, if the stock price remains above £95, Sarah loses the £5 per share premium, but she still owns her shares, which may have increased in value or continued to pay dividends.
Example 2: Writing a put option for income generation
John, an experienced options trader, sells a put option on the same XYZ stock with a strike price of £95. He receives a premium of £3 per share for writing the option. His strategy is based on the belief that the stock will remain stable or rise, and that the option will expire worthless.
If the stock price stays above £95, John keeps the £300 premium (100 shares × £3 premium) as profit. However, if the stock price falls below £95, John will be obligated to buy 100 shares at £95 per share, which could lead to a loss if the stock price drops significantly.
This example highlights how writing puts can generate income, but also carries the risk of being forced to buy the underlying asset at an unprofitable price.
Who should trade put options?
Put options are suitable for various investors and traders, from those looking to protect their portfolios to those interested in speculating on market movements. However, due to the complexity and risks associated with options trading, participants need to have a solid understanding of how options work and their strategies.
Hedgers
Investors who own an asset, such as stocks or commodities, may use put options as insurance. These investors can protect themselves against significant price declines by purchasing put options. This is particularly valuable in volatile markets or during times of uncertainty when the potential for substantial losses is high.
For example, if an investor holds a prominent position in a specific stock, buying a put option allows them to sell it at a predetermined price, providing a safety net against sharp price declines.
Speculators
Speculators, including day traders and those looking to profit from price movements, may also use put options to take advantage of anticipated asset price declines. Unlike hedgers, speculators do not own the underlying asset but profit by predicting that the asset’s price will fall. If they are correct, they can exercise their options for a profit.
Speculators are typically more active in the market and are willing to take on greater risk in exchange for potentially higher rewards. However, they must be able to assess market conditions accurately and manage their positions effectively.
Income seekers
Selling put options can be an appealing strategy for those seeking income from options premiums. Investors who sell put options hope to collect the premium without buying the underlying asset. This strategy works best in markets where the underlying asset’s price is expected to remain stable or increase. However, it’s important to note that this strategy can be risky if the asset price falls below the strike price, forcing the seller to purchase the asset at a loss.
FAQs
What is a call vs put?
A call option gives the buyer the right to buy an underlying asset at a specified price, while a put option gives the buyer the right to sell the asset at a set price. Call options profit from rising prices, and put options profit from falling prices.
What is the difference between a short and a put?
A short sale involves selling an asset you don’t own, hoping to repurchase it at a lower price, while a put option gives you the right to sell an asset at a set price. Short selling requires borrowing assets, while puts are contracts with fixed costs.
What is the difference between bearish and bullish?
A bearish outlook means expecting a price decline, while a bullish outlook anticipates price increases. In options trading, bearish strategies often involve put options, and bullish strategies involve call options, reflecting differing market expectations.
Are puts bullish or bearish?
Put options are typically considered bearish, as they are used to profit from declining asset prices. Buyers of put options expect the underlying asset’s value to drop, allowing them to sell at a higher strike price than the market price.
How to short-sell a stock?
Short selling a stock involves borrowing shares from a broker and selling them on the market, hoping the stock price will decrease. If the price drops, you can repurchase the shares at a lower price to return them to the broker, keeping the difference.
