What is an Option? (Put)

Stock Options are complicated financial instruments that need to be handled accordingly. Always remember “not preparing to win, is preparing to lose.” You must study and understand all the subject matter. We are going to start with a definition of “Stock Option” according to Investopedia which is an on-line dictionary for words and terms having to do with the stock market.

Stock Option: A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.

Well, if you’re a beginner, you can see the strange lingo is already kicking in. Let me try to explain in terms we speak on “Main Street.” There are two types of options, a Call Option and a Put Option. Do not get into this section on Put Options until you completely understand what a Call Option is and how they work. To review here’s a textbook definition of a Call Option:

A Call Option, often simply known as a “Call”, is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the Call Option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument, in our case a stock (the underlying) from the seller of the option at a certain time (the Expiration Date) for a certain price (the Strike Price). The seller (or “writer”) is obligated to sell the stock to the buyer if the buyer so decides. The buyer pays a fee (called a premium) for this right.

Now that you have read “What is an Option? (Call)” along with the definition above and other study material, I hope you understand Call Options enough to move on and get into Put Options.

As the inner workings of long positions are easier to understand than short positions, I guess Call Options are easier to understand than Put Options. It’s strange but many investors who are perfectly comfortable trading Call Options get a little nervous around Put Options. Puts are certainly nothing to be afraid of. When used properly, they can add a whole new dimension to your trading. Let’s take a look at what a Put is, than we’ll look at some examples.

Put options are basically the reverse of Calls. a Call gives the owner the right to buy stock at a given price (the Strike Price) for a certain period of time. A Put, on the other hand, gives the owner the right to sell stock at the Strike Price for a limited time. Let’s discuss owning Puts first, followed by holding a short Put position.

If you own a Put on stock XYZ, this means you bought it from a Put seller. Just like if you own a Call, you bought it from a Call seller. When you buy a Put or a Call you pay the seller a premium. When you own a Put you have the right to sell XYZ at the Strike Price until the Put Option expires. Let’s make an example to explain how you would benefit from owning a Put.

The price of the stock XYZ is at $20 per share. You own 1000 shares. The earnings report is coming out on XYZ this week and you think the stock will have good earnings and the stock will go up. Just in case the stock’s report isn’t as good as you think it will be, you want to have some insurance against the stock moving down. You decide to buy a 10 contracts Put. With the stock at $20 you buy a $19 Put for a 20¢ premium for a total of $200 premium. Remember, the Put gives you the right to sell your stock but it gives the Put seller the obligation to buy your stock if you want to sell. The earnings report comes out and it was not good, and the stock dropped down to $15. If you did not buy the Put you would be down $5 on 1000 shares for a loss of $5000. Since you bought the Put, you have the right to sell your stock to the Put seller for the Strike Price of $19. You sell your XYZ stock to the seller for the $19 for a $1000 loss, plus the $200 premium for a total loss of $1200. If you didn’t buy the put you lose $5000, with the Put $1200. The insurance (hedge) worked out nicely! If you bought the Put with the Strike Price of $20 (At-the-Money) you would have paid a little more for the premium,maybe 30¢, but you would have broke even on the stock and only lost the money you spent for the Put, the premium.

If the earnings came out good and the stock went up to $25, you would not have sold the stock. Remember you have the right to sell, not the obligation. In this case you would only lose the premium. The Put you buy to hedge is called a Protective Put.

Above I mentioned I would discuss a short Put position. Here’s an example of when you might hold a short Put position. First, a short position means you sold something. Let’s say XYZ stock is at $20 and you do not own the stock. You like the stock but you think the price is a little high, but you wouldn’t mind owning it at a little lower price, say $18. You decide to sell 10 contracts of the $18 Put for a premium of 30¢ ($300). A Put seller gives you $300 and they have the right to sell you 1000 shares of XYZ stock at $18 until the expiration of the contract. If he wants to sell you the stock, you have the obligation to buy. Let’s take a look at a few examples how this might play out:

On Expiration Day the stock is at $18 – The Put buyer sells you the 1000 shares (if he wants to) at the $18 Strike Price. He is down $300 he paid as a premium for the right to sell you the stock. You own the 1000 shares of XYZ stock at the price you were willing to pay. And you are up the $300 you received from selling the Put.

On Expiration Day the stock is at $16 – With the stock $2 below the Strike Price, the Put buyer has the right to sell you 1000 shares of XYZ stock at $18 per share. And he will put the stock to you! You received a $300 premium and you have the obligation to buy the stock. The stock will be put into your account and the money ($18 per share) will be taken out. There is nothing you can do about it. You must pay $18 for a $16 stock.

On Expiration Day the stock is at $20 – With the stock at $20 it will not be put to you. And you keep the $300 premium you received for selling the Put. The Put buyer will not put the stock to you at $18 because he can get $20 on the open market. This contract will end with you up $300 and the Put buyer down $300.

Strategy of the Put seller (Short Position)

Most Put sellers do not want to have the stock put to them. At least I don’t! I sell a Put for the premium. In the above example, if the stock is at $20 and I sell the $18 Put, I want the stock to go up. If the stock goes up I will not have the stock put to me. I keep the $300 premium and I move on to the next deal. I would rather not buy the stock, even at a lower price. Honestly, I’m an options trader, I do, but I’d rather not own stock. Stocks go down! When they go down they can stay down for a long time. Plus they are expensive and they eat up my margin. Being an options trader you invest less money and get a greater Rate of Return on the money invested.

Selling Puts gives you a Short Position. If I sell a Put for 30¢ I want the premium to go down. If the premium goes down to 10¢ I can now buy back the Put I sold for 30¢ and only pay 10¢. With a Short Position you sell first and buy later. My premium will increase in value with the stock going up or not moving at all. And the passage of time through Time Decay. If the stock does not move Time Decay will eat away at the premium. It is very important to understand the difference between Long and Short Positions.

Strategy of the Put buyer (Long Position)

Most Put buyers do not want to sell the stock. Most don’t even own the stock. At least for me and most options traders. They buy the Put because they think the stock is going down. If XYZ stock is at $20 and I think the stock is going down I’ll buy the $20 Put by paying the premium. Let’s say it’s 30¢, and I buy 10 contracts. I spend $300. This contract says I have the right to put 1000 shares of XYZ stock to the Put seller at $20 per share. Since I don’t own the stock I don’t want to put the stock to him. What I want is for the stock to go down. If the stock goes down the option I paid 30¢ for will increase in value. If the stock take a big drop the premium can go to 50¢ or 60¢. With the premium at a higher price I can sell my option for that price. If it goes to 60¢ I can now sell my 10 contract option for $600. I bought for $300 and I sell for $600. This can happen in a matter of days, sometimes hours. If it does I doubled my money. The bottom line is, option traders buy and sell options for the premiums not to transfer the stock around.