A put option is a financial contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price (known as the strike price) within a certain period of time.
Put options are commonly used as a way to hedge against potential losses in the value of the underlying asset. For example, an investor who owns a stock but is worried that its value may decrease in the future can purchase a put option on that stock. If the stock price does indeed drop, the investor can exercise the option and sell the stock at the higher strike price, thereby minimizing their losses.
In exchange for the right to sell the underlying asset at the strike price, the holder of the put option pays a premium to the option seller. The option seller, in turn, is obligated to buy the underlying asset at the strike price if the option is exercised.
What is a put option example?
Here's an example of how a put option works:
Let's say you own 100 shares of XYZ company, and you're concerned that the stock price may drop in the coming months. You decide to buy a put option on XYZ, which gives you the right to sell the shares at a specified price (the strike price) within a certain period of time (the expiration date).
You purchase a put option with a strike price of $50 and an expiration date of three months from now, and you pay a premium of $5 per share (or $500 total, since one options contract usually represents 100 shares).
If the stock price drops below $50 before the expiration date, you can exercise the put option and sell your shares for $50 each, regardless of how low the market price may have fallen. For example, if the stock price drops to $40, you could exercise the put option and sell your shares for $50 each, which would limit your losses to $10 per share (plus the cost of the put option premium).
On the other hand, if the stock price stays above $50, the put option would expire worthless, and you would lose the premium that you paid for the option. However, you would still own your 100 shares of XYZ and could continue to hold or sell them in the future.
How do put options make money
Put options can make money in two ways: through exercising the option or through selling the option for a profit.
If the price of the underlying asset (e.g. a stock or an index) drops below the strike price of the put option, the holder of the put option can exercise the option and sell the underlying asset at the higher strike price. The profit is the difference between the strike price and the lower market price, minus the cost of the premium paid for the put option. For example, if the strike price is $50 and the market price drops to $40, the profit would be $10 per share, minus the cost of the put option premium.
Alternatively, if the price of the underlying asset does not drop below the strike price, the put option may still be sold to another investor at a higher price than what was paid for it. This is because the value of the put option increases as the market price of the underlying asset decreases, reflecting the increased likelihood that the option will be exercised in the future. If the investor sells the put option for a price higher than what was paid for it, they can make a profit without ever exercising the option.
It's worth noting that there is always a risk of losing money when trading options, as the market can move in unexpected ways. It's important to have a solid understanding of the underlying asset and to manage risk through strategies like diversification and setting stop-loss orders.
Why sell a put instead of buy a call?
Selling a put and buying a call are two different options trading strategies, each with their own advantages and risks.
Here are some reasons why an investor might choose to sell a put option instead of buying a call option:
1. Generating income: Selling a put option can generate income in the form of the premium paid by the option buyer. This can be a useful strategy for investors who want to generate cash flow from their portfolio.
2. Lower cost: Selling a put option typically requires less upfront capital than buying a call option, since the seller only needs to provide the margin required by the broker instead of paying the full cost of the option.
3. Flexibility: Selling a put option gives the investor more flexibility than buying a call option, since the investor can potentially profit from a variety of outcomes, such as a stable or rising market, or a slightly declining market.
However, it's important to note that selling a put option also carries risks. If the price of the underlying asset drops below the strike price of the put option, the investor may be obligated to purchase the asset at the higher strike price, potentially resulting in a loss. In contrast, buying a call option limits the investor's potential loss to the premium paid for the option.
Ultimately, the decision to sell a put option or buy a call option will depend on the investor's goals.