Typically, put options are a kind of option whose value grows as the price of a stock declines. A put enables the owner to sell a specific stock at a predetermined price, while put sellers agree to purchase the stock at that price. The attractiveness of them is that they can rapidly appreciate a slight change in the stock price. Consequently, this characteristic makes them popular among traders seeking large returns rapidly.
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What Exactly Is a Put Option?
A put option provides you the right to sell a stock at a specified price, the strike price, by a specific time at the expiration. However, this right is not an obligation. The put buyer pays the seller a sum of money known as a premium for this right. In contrast to stocks, which can exist continuously, an option expires and is resolved, either with some value remaining or with the option expiring worthless.
Each contract represents 100 shares of the underlying stock. It is referred to as an option. Contracts are priced based on the value per share rather than the entire value. For example, if it is priced at $1.50 on the exchange, the cost to purchase the contract is $150, or (100 shares * 1 contract * $1.50).
The following are the main components of a put option.
- Strike price
It is the price at which the underlying shares can be purchased.
- Premium
It is the cost of an option for a buyer or seller.
- Expiration
This is the time after the option has expired and been settled.
The Working Principles of Put Options
At expiration, put options are in the money when the stock price is below the strike price. Moreover, it can be exercised by selling the underlying stock at the strike price. In addition, the owner may sell the put option to another buyer at fair market value before the expiration. A put owner profits when the premium paid is less than the difference between the strike price and the stock price at option expiration. Imagine a trader paid $0.80 for a put option with a strike price of $30, and the stock price at expiration is $25. It is worth $5, and the trader has earned $4.20 in profit. If the stock price at expiration is more than the strike price, it expires worthless. The put seller retains any option premium received.
How to Buy and Sell Put Options
An investor must correctly input various options-related criteria to buy or sell a put option. There are dozens of options for every option security. Furthermore, you must choose which one to purchase or sell. Here are the essential components of option trading that you must confirm.
- Underlying security
- Option Strategy
- Expiration date
- Strike price
- Premium
- Order type
It is simple to put an order that is the exact opposite of what you mean, which could cost you a significant amount of money. You should also consider the breakeven price for your trade when setting your order; for example, what price must the stock reach before you make a profit on the option at expiration.
Limit orders are required for trading options to avoid incurring excessive fees. You designate the minimum acceptable price for a trade with a limit order. Your order will not be executed if the market cannot match your price.
The Benefits of Buying Put Options
Traders purchase put options to increase their profit from a stock’s decrease. A trader can profit from stock prices below the strike price until the option expires for a little upfront investment. By purchasing a put, you often anticipate that the stock price will decline before the option expires. Significantly, purchasing puts can be viewed as insurance against a stock decrease. The insurance payout will be made if it falls below the strike price.
Imagine a stock with the symbol WXY trading at $40 per share. You can purchase a put option with a $40 strike price and a six-month expiration for $3. One contract costs $300, equal to (100 shares * 1 contract * $3) multiplied by one contract.
The graph below depicts the buyer’s profit when the option expires at various stock prices.
From the graph below the strike price, the option’s value increases by $100 for every $1 change in the stock price. As the stock falls from $36 to $35, a small 2.8% decrease, the option’s value climbs from $400 to $500, or 25%. Even if the option is in the money at expiration, the buyer has not necessarily made a profit. Here, the premium was $3 per share. Therefore, the put buyer will not begin to earn a profit until the underlying stock reaches $37, which is the $40 strike price less the $3 premium. In this case, the breakeven point for the trade is $37.
Besides, if the stock closes at an expiry between $37 and $40 per share, the put option will retain some value. However, the trader will lose money overall. Moreover, above $40 per share, the put option expires worthless, and the buyer forfeits the entire investment.
Traders anticipating a decrease in a stock’s price are enticed to purchase puts since options amplify a stock’s decline. Consequently, a trader might earn far more money for the same initial investment than by short-selling a stock. It is another method for profiting from a stock’s decline. Using the same $300 starting investment, a trader might short ten shares of stock or purchase one put.
The Benefits of Selling Put Options
If you are interested in trading options, you may buy and sell them. The following are the benefits of selling puts. The payout for put sellers is the exact opposite for put purchasers. Sellers anticipate that the stock price will remain unchanged or climb above the strike price, rendering the put option worthless.
Using the same example as previously, pretend that the price per share of WXY stock is $40. You can sell a put option with a $40 strike price and a six-month expiration for $3. The value of one contract is $300, or (100 shares * 1 contract * $3).
Here is the profit of the seller at expiration.
The profit for the put seller is the exact opposite of the profit for the put buyer.
- The option expires worthless for a stock price greater than $40 per share, and the put seller retains the whole $300 premium.
- Between $37 and $40, the put is in the money, and the put seller receives a portion of the premium, but not all of it.
- Below $37, the put seller will incur losses over the $300 premium received.
The attraction of selling puts is that you receive upfront cash. Moreover, you may never be required to purchase the underlying stock at the strike price. You will profit if the stock price increases over the strike price by expiration. However, you will not be able to increase your wealth as you would by purchasing puts. Your profit is limited to the upfront premium received as a put seller.
Selling a put appears to be a low-risk strategy. However, if the stock falls significantly, you will be required to purchase it at a much higher strike price. Additionally, you will need the funds in your investment account to do so. Typically, investors maintain sufficient cash or margin capacity in their accounts to cover the cost of a stock if it is offered to them. If the stock falls sufficiently in value, you will receive a margin call and be required to deposit additional funds into your account.
For instance, if the stock went from $40 to $20, the put seller would incur a net loss of $1,700, which is the difference between the option’s $2,000 value and the $300 premium received. However, if executed with caution, selling options can be an excellent way to create cash, particularly for stocks you wouldn’t mind owning if their price decreased.
Conclusion
Many people believe options are extremely risky. Genuinely, they can be what people believe if utilized improperly. However, investors can also use it to limit their risk while still profiting from the rise and fall of a stock. You can read the differences of call options and put options in “Call Options: Learn the Easy Concepts of Buying and Selling” article.
FAQs
A Put Option is a type of financial contract that provides the buyer with the right, but not the responsibility, to sell an underlying asset at a predefined price (strike price) within a certain time frame.
A Put Option grants the buyer the right to sell an asset, whereas a Call Option provides the buyer the right to purchase the asset. Put Options are often used to profit when the price of asset declines, while Call Options are typically used to profit when the price rises.
Investors who are concerned about future portfolio losses frequently use put options. Traders who wish to profit from a drop in the price of an asset may also utilize them.
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Read more: Stocks
Source: Bankrate