A put option is a derivative that gives the owner the right, but not the obligation to sell shares of stock at a set price, for set period of time. If you hold a put option you want the price of the underlying stock to decrease, whereas when purchasing a call option, you want the security’s value to rise.
It’s relatively easy to understand why you would want a stock’s price to rise. Most people easily grasp the concept that something they bought or own has increased in price or value. What sometimes can be a confusing subject is how a falling stock price can actually make you money.
- Put options are bought when you have a bearish (market heading lower) view on the market or on a particular stock.
So why do I want to buy a put?
Let’s say that a stock you have been watching has been trending ever lower in price over the last six months. You would like to profit from this price action but you don’t want to bother shorting the stock. A position that can allow you to profit with less risk would be to purchase a put option contract.
If the stock in question is currently trading at $40 and you believe it will fall lower, buying a put at the $42 strike price might be a good strategy. The $42 put would be an ‘in the money’ option because it has $2 of intrinsic value. Intrinsic value is calculated by taking the strike price of the option and subtracting the current price of the stock ($42 – $40 = $2). In the money options have a statistically higher chance of expiring in the money and thus making you a profit.
As the price of the stock falls below $40 your put at the $42 strike price becomes even more valuable.
Sell high, buy low.
A put option at the $42 strike increases in price because the put option gives the owner the right to sell shares of stock at $42 even though the price of the stock is lower. If the stock were to fall to $35 a share your $42 put option would have $7 of intrinsic value, not including any time value that remains depending on how far away expiration Friday is.
Now let’s not forget, with all this talk of profits, that if the stock is at or above $42 at expiration you would lose your entire capital invested in this position. If the put was $1.75 to buy, costing you $175 ($1.75 x 100 = $175) for one contract, that would be the maximum that you could lose. If you were to short the stock to take advantage of falling prices, your risk would technically be unlimited, as the stock could theoretically climb indefinitely.
A good rule of thumb if you are looking to buy options:
- Call up & Put down
If you think the price is heading higher buy a call. When a stock’s price is falling capitalize on the downward movement by buying a put.