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Put Option Explained
Stocks, bonds and ETFs aren't the only securities that trade on financial markets. There are also derivative instruments called options — which include put options. Here’s what you need to know about these financial instruments.
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What is a put option?
A put option is a contract that entitles the owner to sell a specific security, usually a stock, by a set date at a set price. The owner can either exercise the contract or allow it to expire, hence the term “option.” Options themselves are not a true security but rather a type of financial derivative, in that their value is derived from that of another asset. They can be bought and sold like stocks on derivatives exchanges and over the counter by financial institutions.
The mirror opposite of a put option is a call option, which gives the holder the right but not the obligation to buy a security at a set time at a set price. Both types of options allow the parties on each side of the trade to either take what's called a “long” position (betting on the possibility the stock will rise), or to take a “short” position (betting that it will fall).
In the case of a put option, the writer (i.e. the seller) is speculating that the stock will exceed expectations and the buyer is taking the chance it will underperform. This is not the same as short selling, in which an investor sells borrowed shares with the obligation to buy them back later to cover the position. But it presents another, potentially less risky way to take the bearish side in a trade because your losses are limited to the premium you paid for the put option vs. if you had sold the stock short your losses are in theory infinite, as the stock can go up indefinitely and you would be forced to buy back the shares at these prices.
How do put options work?
Buying and selling options
To trade in options, you must have a brokerage account and upgrade to options trading functionality.
TD Direct Investing clients can apply for four different levels of options trading, according to the type of account. Approval is tied to the client’s investing knowledge, income and account size.
Put options are usually bought and sold in blocks corresponding to the right to sell 100 shares of the underlying asset, though the premium is expressed on a per-share basis.
How are put options valued?
Until the put option expires, it has a value. For example, if the strike price is $50 and the stock is trading for $45, its intrinsic value is $5. If exercised immediately, the holder will have profited $5 per share minus the premium they paid for the option. If a week passes and the stock rises to $47, the option's value will shrink. If the stock is trading above the strike price, the option is “out of the money” and its value will be negligible, based only on the remaining duration of the option and the odds the stock sinks below the strike price in that time frame.
Short-term options of less than a year are typically written in anticipation of an event that could affect the stock’s price. For example, if you write a put option, then you are hoping that the stock price will continue to trade flat, go up or trade sideways. If you sell a call option, you are hoping the stock price will continue to trade flat, go down or trade sideways. In either case, you can expect to collect the option premium. Long-term options of more than a year are often used to speculate on the stock’s possible decline. They tend to come at a higher premium owing to the longer period the stock has to dip below the strike price. The intrinsic value plus the duration of the option equals the value reflected in the premium.
What does it mean to write a put option?
When an investor or institution writes a put option, they are essentially offering to buy a certain number of shares in a particular company by a certain date for a certain price. Although the option may change hands multiple times, it’s the writer who remains responsible to fulfill the contract and buy the stock. Writing options provide the writer with a source of revenue for taking on what they consider an acceptable risk. It also gives them a means to accumulate a position in a stock they like and think has a higher intrinsic value than the current market price.
Put option strategies and risks
Protective put strategy: The buyer of the option is essentially paying to offload risk. If a stock they hold goes down, they know they can sell that company at the value denoted on the option, known as the strike price. This way, they can limit their losses or lock in their gains on a holding. It sets a floor for the stock’s value up until the expiry date.
Covered put strategy: Where the writer of a put option owns a short position in the underlying stock (speculating that the company will decrease in value), the transaction is known as a "covered put strategy". If the stock goes down, their losses on the put contract will be offset by gains on their short position.
Naked put strategy: When the writer or seller of the put option has no position in the underlying shares, it is known as an uncovered or "naked put." They stand the risk of paying more than the market price to acquire the stock should the stock go down. The loss will be very substantial if the stock plunges toward zero.
The holder or buyer of a put option has no risk other than losing the premium they paid, because they are under no obligation to exercise the option.
A put spread is a strategy that involves buying and selling put options on the same stock simultaneously, though not necessarily at the same strike price. In a bullish put spread, you would sell put options at the higher strike price and buy put options at a lower strike price. It is a suitable option strategy for generating premium income or buying stocks at effective below-market prices.
A bearish put spread works the other way around, generating a return when the stock declines. In both cases, the simultaneous purchase and sale of put options can limit the risk on the trade, in contrast to a naked put, which comes with greater risk.
Things to know about put options
Advantages: Put option spread strategies help investors manage risk. Another part of their appeal is that they are market-neutral: You can make money whether the stock market is going up or down. But options strategies can be complex and are not for every investor.
Risks: A writer of naked puts risks losing up to 100% of the value of stocks that decline toward zero. Otherwise, the risks are foreseeable. A buyer of a put option risks only losing the value of the premium they paid should the option expire unused.
Two examples of put option strategies
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Protective put or married put strategy: An investor buys a volatile stock they expect to go up. They can also buy put options as a kind of stop-loss strategy to sell the stock at an acceptable price in case an event doesn’t turn out as expected.
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Naked put strategy: A fund manager may write puts to generate additional income from a portfolio at the same time as they accumulate holdings in securities they like.
Put option FAQs
Why would you buy a put option?
To manage portfolio risk. If the put option's underlying stock goes down, you can sell that company at the value denoted on the option, known as the strike price. This way, you can limit losses or lock in gains on a holding. It sets a floor for the stock’s value up until the expiry date.
How do put options work?
They give the holder the right, but not the obligation, to sell the stock for a pre-agreed price.
How does the value of a put option increase?
The holder — or buyer — of the option profits when the stock price declines below the strike price before the expiration date. The writer — or seller — of the put makes money from the premium the buyer pays to purchase the option.
How does a put option decrease in value?
One reason the put's intrinsic value is decreasing would be because the stock is rising toward the strike price.
What is a put spread?
There are multiple strategies for playing puts, such as buying and selling puts on the same stock at the same time, known as a put spread.
What happens if a put option is not sold?
If the option expires without being sold or exercised it is then worthless.
What happens if a put option is sold?
If you are the writer (or seller) of the put option, you may be required to buy the underlying shares at the price set. If you are the buyer (or holder) of the put option and you sell it to another buyer, you have no further rights or responsibilities with respect to the contract terms.
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