Put Option

[Igor 10]

A put order is one of two types of orders that an option trader can make (the other being a call order). The trader can either choose to buy a put option or sell one.

 

Buyer: The put option buyer has the right to sell the underlying asset, but is in no way obligated to do so. The put option buyer can choose to either exercise his right to sell on or before the put option's strike date, or they can let the option expire.

 

Seller: The put option seller (writer) has the obligation to buy the underlying asset at its strike price, if a put buyer exercises their right to do so on or before the option's expiration date. The seller receives a premium (option market price) from the buyer for taking this risk.

 

Investors who own assets can also buy and sell put options to protect their investment. Put selling and put buying have different functions and earn profits for investors in different ways.

 

What is a put option?

A put option is a contract that's connected to an underlying asset, normally a stock or commodity. Every put option contract has a fixed price (strike price) that each trader must honor on, or before, a fixed date (strike date). The terms and responsibilities under the put contract differ depending on whether the trader is the buyer or the seller.

 

Buying a Put

Traders who buy put options are betting that the market price of the underlying asset will go down. Put options carry a premium, which varies depending on price and how close the execution is from the strike date. Usually, one put option contract gives the buyer the right to sell 100 shares of the underlying asset. A put buyer pays a premium for each share covered under the put contract. If the asset's market price retreats from the put option's strike price, the call buyer will exercise his right to sell the shares. If the market price is higher, the trader will just let the option expire, resulting in a loss in whatever they paid in premiums.

 

Example: GE is trading at $20 (market price)

 

1) Put Option Available: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) Put buyer has $2200 in their investment account.

3) Trader buys put option for $200 (100 x $2 (premium cost)).

 

Result one: GE hits $10. The put buyer buys 100 shares at the market price for $1,000. Then, they exercise their right to sell the 100 shares at $20 for $2000. Their total profit is $1,000 ($2000 shares sold - $1,000 shares bought). The investment nets $800 profit (400%) after subtracting their $200 in premium costs.

 

Result two: GE hits $30. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the put buyer would lose $200.

 

Protective Put Buying

Traders who own assets listed at auction and who are waiting for the market price to go up (going long), can buy put options to protect their investment if the market price should unexpectedly fall.

 

Example: GE is trading at $20 (market price), and the trader owns 100 shares.

 

1) Put Option Available: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) Trader buys put option for $200 (100 x $2 (premium cost)).

 

Result one: GE hits $10. Their stock loses $1000. The put buyer buys 100 at the market price for $1,000. Then, they exercise their right to sell 100 shares at $20 for $2000. Their total profit is $1,000. This offsets their loss and decreases it to only $200 after adding premiums paid.

 

Result two: GE hits $30. Their stock gains $1000. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the option put buyer would sill gain $800 after deducting premiums.

 

Selling a Put

Traders who sell put options are betting that the market price of the underlying asset will rise. Put options carry a premium that goes directly to the seller. If a put buyer does not exercise their option, the call seller keeps the premium. On the contrary, put option buyers who exercise the option, obligate the put seller to buy the underlying asset at tthe strike price.

 

There are two types of put sales. A covered put sale occurs when the seller actually owns the asset. Traders make naked puts when they do not own the underlying asset. Selling puts have a highest risk factor and only expert traders should carry out this kind of strategy.

 

Covered Put

A covered put occurs when the trader owns the underlying assets for sale and is shorting them at auction. Covered put sellers make a profit when the market price goes down or breaks even. Significant losses occur if the market price rallies.

 

Example: GE is trading at $20 (market price), and the trader owns and shorts 100 shares.

 

1) Put seller writes the option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) A put buyer buys the option and put seller receives $200 in premiums.

 

Result one: GE hits $10. Their short stock gains $1000. Put buyer exercises the option and the put seller uses the $1000 to buy 100 shares at the market price from the buyer. The put seller makes $200 from the premiums.

 

Result two: GE hits $30. Their short stock loses $1000. The put option buyer lets the contract expire. In this example, the put option seller would suffer an $800 after subtracting the premium.

 

Naked Put Options (Uncovered)

This type of put selling involves writing a put option on an asset that is not owned. The naked put writer will need to sell shares if the put buyer exercises the option.

 

Example: GE is trading at $20 (market price).

 

1) Put seller writes the option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

2) A put buyer buys the option and put seller receives $200 in premiums.

 

Result one: GE hits $10. Put buyer exercises the option and obligates the seller to buy 100 shares at $20, so they pay $2000 for stock worth $1000. The put seller loses $800 after adding premiums.

 

Result two: GE hits $30. The put option buyer lets the contract expire. In this example, the put option seller would gain $200 from premiums collected.

 

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