Put Options: Definition, Calculation & Example

Learn what is a put option. See trading examples and understand when you should consider buying (or selling) put options.

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Betting against a stock is a thing. It's called a put option. It's for those investors who think a particular stock price will decline.

You can even cover the stocks you sold short with a put option.

Did we just make your head spin? Don't worry - by the time you're done reading this article, you'll understand what you need to know about put options. In general, this strategy is recommended for people who have experience in stock trading.

So, you might need to get your feet wet first. But explore the information below - you might find yourself able to invest in more stocks than you thought possible.

What Is a Put Option?

While not as common as call options (when the owner is reserving the right to buy shares of an underlying stock), put options can be just as profitable.

• A (bought) put option contract allows the owner to sell a stock at a specified price. The price is what's known as the predetermined option strike price. But there's a time limit: The transaction must occur within a specified time frame or the right to sell expires.

• A (sold) put option contract gives you the obligation to buy the stock at the strike price, should the price of the underlying stock shares drop. Again, there is a time limit. If the stock's price is at or above the option strike price at expiration, the option expires worthless.

  You have the potential to walk away with the premium from the sale of the contract in hand. The risk you take, however, is if the stock's price decreases. If it does, the buyer may execute the contract, obligating you to buy the shares at the higher strike price. Your loss could be offset by the premium made, but the risk for loss is unlimited.

Each of these options contracts is worth 100 shares. When you buy one option put contract, you are buying the right, not the obligation to sell 100 shares of the underlying security at the strike price.

Understanding Obligation

Buying a put option gives you the right, not the obligation to sell the specified shares of stock at the strike price.

You decide whether you want to execute the contract and sell the stock at the strike price. Selling an option put, on the other hand, gives you the obligation to buy a specified number of shares of the stock from the buyer of the put. You can't decide you don't want to buy the stock - you are contractually obligated to do so if the buyer executes the contract.

How Dividends and Options are Different

In the world of finance, options and stock dividends may look similar. In both cases, you have the potential to make more than you would just buying or selling stocks.

However, options are not a sure thing. They are subject to the market volatility. The stock's price must meet specific requirements stated in the in order for your options contract to be profitable.

Dividend stocks pay every stockholder as long as the company has the money to pay out. While not a sure thing, they offer a slightly higher guarantee than options.

How Do You Buy a Put Option?

Options traders buy a put option when they think the market will go down. The idea is to have the contract with a higher strike price. When the stock declines, they have the right to sell their shares of the underlying stock at a higher specified price - and walk away with a profit.

You buy an option put contract for a premium. Let's say you can buy a put option for ABC Company for a $2 premium. You'll pay $200 for the contract. Let's say the strike price is $50. The current market price of the stock is $50. You have a hunch that the stock will lose value within the next 3 months. You buy a put with an expiration 3 months out.

Let's say the stock declines to $45 within 3 months. You can execute your contract. This means you can sell 100 shares of the ABC Company stock for $50 per share. You don't have to own the shares either. You can buy them on the market for $45 or $4,500. You can then turn around and sell them for $50 or $5,000.

Your profit is $500, but don't forget about the premium. You paid $200. So you walk away with a net profit of $300.

If the stock's price didn't fall, you wouldn't execute the contract. Instead, you'd let it expire. The most you would be out is the $200 premium.

What Happens if Your Bought Put Expires Worthless?

If your stock does not meet the specified requirements of your options contract, it expires worthless. This is one case where you wouldn't have to do anything.

There isn't a trade to make. If you bought the put, you lose your premium. You pick up the pieces and try another investment.

What Are the Benefits of Buying a Put?

Buying a put is a fairly safe investment strategy. It allows you to take advantage of a declining market with little capital. At the most, you have the potential to lose your premium. You know your maximum loss going into the investment. If stock prices don't fall, you don't have to do anything.

Your maximum upfront investment is the premium. You don't have to buy the stock unless you execute the put. This minimizes your investment. If, on the other hand, you shorted the stock, you'd have to buy a specified number of shares at some point. You borrow the shares in the hope that you'll be able to buy them on the market at a lower price.

Knowing what you stand to lose makes buying a put a much safer investment, especially for beginning option traders.

Understanding the Right to Exercise

When you buy a put, you have the right to sell a stock at the specified strike price.

In other words, you have the right to exercise the contract. In the above example, you can exercise your right to sell the stock at $50, rather than its market price of $45. If the stock's price remained at the $50 market price, you would not exercise your contract. It would expire worthless and you would be out the premium paid for the contract.

How Can You Sell Puts?

It's also possible to sell puts. As the seller, you are known as the writer. The seller is on the opposite end of the spectrum. He wants the price of the underlying stock to increase rather than decrease. If the price does increase, you walk away with the premium the buyer paid. You also don't have to buy the stock.

You take the risk that the stock's price won't fall. If the stock declines, you have the obligation to act upon the executed contract. You must then buy the 100 shares of the underlying stock at the strike price. Your potential loss equals the total cost of buying the shares of stock minus the premium you collected.

If the stock's price doesn't fall, the contract will expire unused. This leaves you with the premium in your pocket.

There are two types of short puts you can sell - covered puts and naked puts.

• A covered short put position occurs when the put writer sells stocks short first. He then writes a short put to protect his specific investment and minimize his losses. Here's an example.

  ABC stock is trading for $50 today. John takes a short position on ABC stock and then writes a covered put. He sells the put for a $2 premium and with a 3-month expiration. The strike price is $45.John collects $200 up front for the contract.

  Then, 3 months later, before the contract will expire, the stock closes at $40. The buyer executes the contract. This means John has the obligation to buy the stock at the option strike price of $45.

  John already made $5,000 when he took the short position at the start of the contract. He must now buy the stock from the executed put for $45 per share. This costs John $4,500. John walks away with a total of $700. He made $500 on the transaction, plus the $200 initial premium.

  Now, if the stock increased to $55, the covered put option expires worthless. It's called "out of the money." John would walk away with a significant loss. He would have made $5,000 from the short sale position. But then he'd be on the hook for $5,500 to cover the short sale. His net loss would equal $300 after taking the premium into consideration.

  Shorting a stock: When you take a short stock position, you're selling shares of an underlying security that you don't own. Investors do this when they think stock prices may fall. They sell stocks they don't own in the hopes that they'll buy them at a lower price. They can then walk away with a quick profit.
  

• As for uncovered, or naked, put positions, the put writer doesn't short the stock. Instead, he is on the hook for the stock only if the buyer executes the put. In other words, the option must be in the money.

  If the buyer executes the put, the put writer has the obligation to buy the stock at the current market price. Here's an example:

  ABC stock currently trades for $50. John writes a naked put with an option strike price of $50 with an expiration of 3 months. He makes a $2 premium.

  If in 3 months, the market price of the stock falls to $45, the buyer will execute the contract. This means John must buy the stock for $50 per share and can only sell it for $45 per share on the current market. John walks away with a loss of $300. Here's how:

  $5,000 paid for the stock - $4,500 made on the market + $200 premium = $300 profit.

What Happens if the Option Expires Worthless?

If you sell a put and it expires worthless, you don't have to do anything.

However, you are in a better position than a worthless bought put. When you sell a put, you pocket the premium. You want the contract to expire worthless. It means you keep the premium and don't have to buy any stocks from the buyer of the option.

What Are the Benefits of Selling Puts?

Selling puts requires plenty of knowledge about stocks and options. It's not for the novice investor. If you do get into it, though, you may experience the following benefits:

• If the stock price doesn't fall, you walk away with a specified profit from the premium collected.
  
• Even if you do suffer a loss, you can offset it with the premium collected for the contract.
  
• You don't have to have a lot of capital even if the put is executed as long as it's a naked put.

It takes some work to educate yourself on the best moves to make, but selling puts can help diversify and strengthen your portfolio.

Trading ETF Options

Most traders trade options of specific underlying securities or those that follow a major index. You do have the option to trade ETF options as well, though.

You won't find these options traded as frequently. However, if you have a specific interest in a market segment, you may want to try your hand at ETF options.

Should You Use Options as Part of Your Retirement Investments?

Options contracts are volatile and risky. If you are a conservative investor or don't have a lot saved for retirement yet, options may not be the best choice.

You often have to trade large volumes, at least 5 contracts, to see a decent return. If you are trying to save for retirement, small, incremental returns will make it hard to achieve your goals. If you have a diversified portfolio, though, you may try dedicating a small portion to options if you want to try your hand at it.

The Final Word

Buying and selling puts can help you make money without a large amount of capital. It can also help hedge against losses when you short a stock.

As you figure out the best strategy, make sure to take commissions into consideration. Shop around to find the brokerage with affordable commissions but plenty of support. This way you can maximize your efforts buying and selling puts.

And do be sure to read up on investment strategies and market and industry news. Always do your homework on the companies you're investing in as well as the overall market.