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Put options explained

Understanding how put options work can provide valuable insight into managing risk and seizing opportunities in the financial markets.

Put options are a basic options trading strategy that investors and traders use to speculate on or hedge against potential declines in the price of an underlying asset.

Put option buyers may believe the underlying asset’s price will decline over a certain period, whereas put option sellers typically believe the asset’s price will remain stable or rise. However, both parties can use put options in their trading or hedging strategies.

Understanding how put options work can provide valuable insight into managing risk and seizing opportunities in the financial markets.

Put options explained

A put option is a financial contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a defined price — the strike price — within a specific time frame.(1)

The buyer, also called the holder, pays the option seller, also called the writer, a fee for the right to buy the underlying asset before the contract’s expiration date. This fee is known as the premium.

A put option grows in value for the option holder as the asset’s price decreases and loses value if the asset’s price rises above the strike price.

You may want to buy a put option if you suspect the underlying asset’s price will decline over a certain period.

Contrast a put option with its counterpart, the call option. Call options give the holder the right, but not the obligation, to buy the underlying asset at the strike price.(2)

With call options, the option holder believes the asset’s price will rise above the strike price, whereas the seller wants the price to remain stable or below the strike price.

How put options work

An equity options contract typically represents 100 shares of the underlying asset. When you look at put option pricing on an exchange, you’ll see it’s listed on a per-share basis. For example, a put option may be listed for $2, but the contract will total $200 (one contract of 100 shares x $2 per share = $200).

Even though a put option represents the right to sell 100 shares of an underlying asset, investors don’t need to own the asset to buy or sell puts.(3)

Buying put options explained

When you buy a single equity put option, you’re purchasing the right, but not the obligation, to sell 100 shares of the underlying stock to the option writer at a predetermined price any time before the option expires.

If the stock’s market price falls below the strike price, exercising the option to sell can be beneficial.

However, if the stock price rises above the strike price, it’s generally more advantageous to let the option expire worthless.

In this case, your loss is limited to the premium you initially paid for the option.

Example: You’re the put option buyer and want insurance

Let’s say you own 100 shares of ABC Corp, which is currently trading at $55 per share. To protect against a potential drop in the stock’s price, you purchase a put option with a $50 strike price that expires in one month. You pay a premium of $2 per share for the contract, totaling $200 (one contract of 100 shares x $2 per share = $200).

Prior to expiration, the stock is trading at $40 per share, so you exercise the put and sell your 100 shares at the $50 strike price despite the lower market price. Therefore, you receive $5,000 from the sale ($50 strike price x 100 shares).

To calculate your profit or loss, you must account for both the premium cost ($200) and the difference in stock price from when you bought the shares.

If you purchased at $55 (totaling $5,500) and sold them at $50 (receiving $5,000), you would incur a loss. The option protected you from a more significant loss (selling at $40 per share would have netted only $4,000), but the protection came at a cost. Thus, the total loss considering the premium would be $700 ($500 loss on the shares plus the $200 premium).

However, if the share price had risen above the $50 strike price, you would indeed opt not to exercise the put option, resulting in a loss limited to the $200 premium paid.

Selling put options explained

A put writer, on the other hand, earns the premium upfront but stands to lose significant money if the asset’s price drops below the strike price. This is a much riskier investment strategy because, unlike the put buyer — whose losses are limited to the premium — a put seller’s losses are impossible to predict.

The lower the asset’s price drops below the strike price, the bigger the loss to the option writer. That’s because the put writer must buy the shares at the strike price, which is higher than the stock’s current market value.

Example: You’re the put option seller

ABC Corp is trading for $20 a share, and you’re selling put options with a strike price of $20 for a $2 premium per share. If the share price rises before the expiration date, you pocket the $200 as pure profit. However, your earnings are limited to just the premium.

Now, let’s imagine the shares are trading at $10 a share before the expiration date.

The option holder chooses to exercise the put and sell you the shares at the $20 strike price. As the option writer you are obligated to buy, so you must purchase the 100 shares at $20 each for $2,000. But they’re only worth $1,000 on the market, so your loss comes to $800 when you account for the $200 premium you received.

Advantages and disadvantages of put options

It’s important to be aware of the risks and rewards of trading put options before attempting to implement this investment strategy.

Advantages

  • Hedging against price declines. If you expect an asset’s price might go down, buying a put option allows you to sell the underlying asset for more than its market value.
  • Potential for high returns. The more the asset price declines, the higher the returns when you opt to sell.
  • Controlled risk. When you buy a put option, your risk of loss is limited to the premium you paid to the option writer.

Disadvantages

  • Time decay. The value of a put option decreases faster as it nears its expiration date, particularly if it isn’t moving in the direction you had hoped.
  • Potential for significant loss. Unlike the put buyer, whose maximum potential loss is limited to the premium paid, the put writer’s potential losses can be substantial and are theoretically unlimited.
  • Limited earnings for put option writers. If you sell put options, your income potential is limited to the premiums paid.

Put vs. call options explained

Call options are the reverse of put options. If you purchase a put option, you’re buying the right, but not the obligation, to sell an underlying asset at the strike price and the option writer is compelled to buy it. If you buy a call option, by contrast, you’re purchasing the right to buy the underlying security, and the option writer is obligated to sell it.(4)

In a nutshell, you’d buy a put option if you believe the underlying asset’s price might drop below the strike price. But you might buy a call option if you predict the exact opposite — that the share price of the underlying security will exceed the strike price.(5)

Why use a put option?

Buying a put option might be a smart move if you believe the underlying asset’s price will drop below the strike price. That way, you profit from selling the underlying asset at the strike price, which is higher than the market value after the asset’s price has dropped.

An investor might choose to sell put options if they believe the asset’s price will remain stable or at least not fall below the strike price, but gains are limited to the premiums paid for the options. This strategy is much riskier because if the share price goes below the strike price, the investor is forced to buy the asset at the strike price, which is for more than it’s currently worth. And the further the price drops, the more the investor stands to lose.

Bottom line

Put options are a basic options trading strategy that investors and traders use to speculate on or hedge against potential declines in the price of an underlying asset.

Put option buyers may believe the underlying asset’s price will decline below the strike price, whereas put option sellers typically believe the asset’s price will remain stable or rise. However, both parties can use put options in their trading or hedging strategies.

Buying put options offers the potential for significant rewards, but selling puts carries bigger risks for the option writer. To learn more about trading options, check out our detailed guide on how to trade options.

Frequently asked questions

Why buy put options?

You might buy put options for two main reasons. Either you want to make money because you expect an asset to lose value, or you’re trying to protect your investment by hedging against a potential loss.

How do you make money on a put option?

If you’re a put seller, your earnings are limited to the premiums paid for the options. As a put holder, you make money if the share price of the underlying asset drops below the strike price and you sell at the higher strike price.

Is it riskier to buy or sell put options?

It’s riskier to sell put options than to buy them. If you’re an option writer and the asset’s price declines, you may be forced to buy the underlying asset at the strike price, even though it’s more than the asset’s current worth.

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To make sure you get accurate and helpful information, this guide has been edited by Matt Miczulski as part of our fact-checking process.
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Writer

Lacey Stark is a freelance personal finance writer for Finder, specializing in banking, loans, investing, estate planning, and more. She has 20 years of experience writing and editing for magazines, newspapers, and online publications. A word nerd from childhood, Lacey officially got her start reporting on live sporting events and moved on to cover topics such as construction, technology, and travel before finding her niche in personal finance. Originally from New England, she received her bachelor’s degree from the University of Denver and completed a postgraduate journalism program at Metropolitan State University also in Denver. She currently lives in Chicagoland with her dog Chunk and likes to read and play golf. See full bio

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