Making Sense Of A Put Option
Among the array of derivatives of the classic share of stock that a corporation issues when trying to raise money is the stock option contract. An option doesn’t actually give you ownership of the shares of stock (or any other financial asset) underlying it, though. Rather, it gives you the right, but not obligation, to buy or sell the shares offered within that same option.
BUY VERSUS THE PUT OPTION
A right to buy the shares underlying an option contract is known as a “call option.” A right to sell the shares underlying an option is called a “put option.” In the case of selling the shares underlying an option contract you want the predetermined, set price (known as the “strike price”) of the stock shares to decline before an exercise of the option to sell them occurs. The right to sell at a certain price or the right to buy at a certain price can be powerful tools indeed! Timing is everything!
INCORPORATING OPTIONS INTO YOUR INVESTMENT STRATEGY
Including the buying and selling of options into an investment strategy has grown in importance in this new century. Buying options -- in which an individual investor hopes that the strike price of the underlying shares increases before he exercises his right to purchase them at that lower price -- is straightforward enough because you’ll, in effect, be “buying low and selling high.”
Selling put options tends to be a bit confusing, however, to the small individual investor, though the potential for great profit (as well as great loss, admittedly) can be impressive. But you shouldn’t shy away from put options once you’ve learned how they’re successfully traded, something that can take time and require no small amount of training and education.
TRADING IN PUT STOCK OPTIONS
Basically, put stock options gives you the right to sell the underlying shares at their strike price by a mutually agreed-upon option exercise date. You’ll be paying a premium to the put option contract’s writer (its seller) for the right to sell the underlying stock at their strike price, and you need to hope their price heads lower in order to make profit for yourself. If the price of the underlying shares heads higher you don’t exercise your option and you’re out only the premium you paid to the option writer in the first place.
HOW TO TRADE IN PUT STOCK OPTIONS
Learning the ins-and-outs of put options requires far more space and time than is available here. Suffice it to say that when you’re considering put stock options you should do so as the option contract’s seller or writer, but only if you have a solid belief that the price of the shares underlying that contract will drop below the agreed-upon strike price. Of course, the option’s buyer (i.e. the person paying you the premium) generally expects the price of those shares to rise above their strike price by the option’s exercise date.
If the price declines you’ve made a nice profit from the premium, because the buyer won’t exercise his option. If they rise, though, you may have to cover or “make good” by finding the shares out on the market, at their market price, and delivering them to your buyer at their lower strike price, thus causing you a net loss and the buyer a net profit, after all expenses for you both (such as the premium paid by the buyer, brokerage fees and the money you spent to obtain those shares) are factored in.
BEAR MARKETS AND PUT OPTION CONTRACT TRADING
A “bear” market is one in which the outlook by investors participating in that market is that stock prices -- or other financial assets such as bonds -- are on the decline and that “short selling” of such stocks or other financial assets and derivatives such as option contracts is in order. In a bear market, then, trading in the “put option” can make great financial sense.
SHORT SELLING VERSUS THE PUT OPTION
The practice of short selling a stock, when in a bear market, as well as trading in put options (in which you hope the price of the shares of stock underlying that “put” will drop below their agreed-upon price known as their “strike price”) are both bearish strategies. Often, a bearish strategy is speculative and is also called “speculation” on the part of investors dealing in such strategies. Such speculation by investors large and small, institutional as well as individual is employed to “hedge” downside (market decline) risk in a portfolio of financial assets or even just a specific stock. You’re “covering your bets,” in other words; in case the market really “heads south.”
“Short selling” a stock, or an entire portfolio, involves the sale of stock that you don’t actually own at the time you sell it, but has been borrowed and already sold on the market. When you short-sell in this manner you create for yourself a “short position” in that stock or other security or asset. By doing this, you hope to drive the price of that security lower and if it declines as you expect it to do, you’d simply buy it back at the lower market price you helped create and pocket the difference. Your profit is the margin between what you sold it for and what you later had to buy it for in order to deliver it to the buyers you originally sold the stock to.
A put option contract gives to the buyer a right but not an obligation to sell the stock underlying the contract at an agreed-upon price (its “strike price”) before the contract’s exercise expiration date -- typically the Saturday following the third Friday of the month in which the put option expires.
THE PUT OPTION AS A BEARISH STRATEGY
Put options are also bearish. You’re hoping that the price of the stock in the put option drops beneath the strike price, in fact. If the stock underlying the put option does decline, the put option contract will appreciate in price. However, if the stock contained in a put option stays above the strike price the put will normally expire worthless . In put options you’re speculating that the price of the underlying stock in them will decline, making you money off the premium you collect from their buyers to purchase those option contracts and who also won’t end up exercising their options to buy.
USING THE PUT OPTION TO HEDGE AGAINST RISK
Experienced investors (and it really does take education and experience to deal in puts) use put options to directly hedge (i.e. reduce) risk. For example, if you’re concerned about a decline in the petroleum sector in which you’re heavily invested you’d buy put options on the petroleum stocks in your portfolio in case their stock prices begin a decline. You might lose on the actual stocks as they drop in share price but you could gain a hundred-fold from smart use of put options on those same stocks. Should their price actually decline, the put option contracts you sold, to buyers speculating in a bullish manner that prices would rise, would generate a nice profit for you just from the put option contract premiums you collected.
For further study on the put option, we recommend these fine resources: