Put Options Basics: How to Protect a Position or Earn a Profit If a Stock Price Declines

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What is a put option? A put option gives the purchaser the right but not the obligation to sell 100 shares of the underlying stock for a set price, the strike price of the option. This is true except at expiration, when a “long-in-the-money put option” is automatically exercised by the Options Clearing Corporation unless you instruct your broker not to exercise it.

The basic definition or characteristic of put options is that they increase in value when the underlying stock decreases in price. So option pricing on put options will increase when a stock declines. Two common options trading strategies include purchasing the put option to attempt to profit from a stock declining or using it as a synthetic stop loss to protect the shares of stock you own against the price going down.

Some options can’t be settled with the sale of the underlying like an index (you can’t buy an index!), in which case the option would be settled in cash and is referred to as an index cash settled option. Put options are limited by time of course, meaning that they have an expiration date associated with them, as do all options.

Let’s look a little deeper at how a put option can act like insurance for the stocks that you own:

Say you own 100 shares of IBM which is trading at 100. IBM is coming out with earnings in a few days and you are concerned about your position if earnings are bad. However, you don’t want to sell your shares at this point in time. So you decide to protect your shares by purchasing the IBM 100 strike put option that expires in 30 days for $1 or $100 ($1 x 100).

This is like buying an insurance policy for 30 days.

Purchasing this put option gives you the right to sell your stock for $100 no matter how much it falls. If earnings come out, and IBM goes up, you make money on the stock, but lose some of the options premium you paid for the put you bought. It is like you bought car insurance, but you never got into an accident. So you lose the price you paid for the insurance. Unlike insurance policies though, if earnings came out and you still had 29 days to expiration, your put option might still have some value allowing you to sell your put and close out the position.

Now let’s say that IBM comes out with poor earnings and drops to $90. If you had done nothing, you would have a paper loss of $10 x 100 shares, or a $1000 loss. Instead you have a couple of choices at this point because of your purchase of the put option as protection:

1) You can exercise your option to sell or “put” the stock to someone for the strike price of $100. If you do that, your loss would be $100, or the cost of the put.
2) You could sell your puts which have now gone up in value and are now profitable in-the-money options. After the decline their value will be approximately $10 in value. If you sell the put your profit is $1000 minus $100 paid = $900. In this case, remember, you still own the stock.
There are many reasons why you might choose one or the other based on tax issues, future directional opinions as to where you believe IBM is going etc., etc. But for now, the put option did its job of acting as an insurance policy for your shares.

Our second trade scenario is to use put options is as a speculative trade, believing that a stock might be going down. There is no need to short the stock and worry about unlimited risks associated with that or the high margin requirements. If you buy a put you have a fixed cost and earn money if you are correct and the asset goes down (in very simple terms).

Time value, magnitude of the move, and volatility all have an impact on the option price, but for now let’s keep the example simple and not focus on those other variables. You don’t own IBM but you think that earnings are going to be weak so you invest $100 with the assumption that IBM will decline and thus profit from the increased value of the put you purchased, again ignoring time decay and volatility.

A quick review if you are a new options trader: the very definition of put options is that as the underlying security decreases in price, the value of a put option will increase, time decay and volatility not-withstanding. This is one key options trading strategy to consider if your analysis concludes there is more supply than demand and you believe it will result in a price decline in a certain amount of time.

As with call options, you can buy puts on many different asset classes including stocks, ETFs, indices, futures, and commodities. Put options can be a great way to protect a position you have in your portfolio to help get mitigate risk and/or lock in most of your profits without having to sell your shares. Puts also provide a way to play the downside of the market without having to initiate a short-sale position and experience the unlimited risk and margin requirements of short-stock positions.

Seth Freudberg,

Director, SMB Options Training Program

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