9-03 Put Options

9-03 Put Options


Whereas a call option gives the holder the right to buy the stock at a certain price, a put option gives the holder the right to sell the stock at a certain price. A trader that buys a put option believes that the price of a security will fall in the near future. You are buying the right – not the obligation – to sell the security for an agreed upon strike price in the future.

Let’s look at another example using Yahoo! (YHOO) stock. Suppose you think YHOO’s stock price is too high and you expect a sell off. You buy a YHOO October 25 put option at $1, or $100 per contract. This gives you the right to sell 100 shares of YHOO at $25 at any time prior to its expiration on the 3rd Friday in October. If YHOO shares are at $20 by the expiration date in October, then you can exercise your put option and sell shares for $25 when the market is paying only $20 a share, giving you a $5 per share profit and an overall profit of $400 (100 shares x $5 – $100 cost) for that one option contract.

If the price of Yahoo! is more than $25 by the expiration date, then your option to sell YHOO shares at $25 expires worthless.

Put options offer protection on the downside to limit your losses without severely restricting your profitability. For example, say you already own 100 shares of Yahoo! Stock and you have enjoyed a nice 50% gain in the last 6 months as the stock has gone from $20 to $30 per share. If you buy a put option at the strike price of $30, then you are effectively locking in your price gains for the duration of the options contract without having to sell any of your YHOO shares. There is a cost for this contract, just like there is a cost to be paid for any real-world insurance contract.

Mark's Tip
Remember this old saying: “stocks slide faster than they glide” meaning that a stock’s price will generally tend to fall quickly while price rises tend to be gradual over time. For me, this has always made put options more attractive to speculate with since the time to see the price of a stock fall is usually shorter than the time to see it rise the same amount.

As with Call options , you can be a buyer or seller of put options to create protection or arbitrage positions.

Puts are similar to “short positions” (when you sell “borrowed” securities that you do not yet own outright).

Like all other investment strategies, you might win or lose with options. In both put and call options, you must understand the difference between buyers and sellers. The buyers of put or call options are NOT obligated to buy or sell at the agreed upon price. However, call and put sellers (called options “writers”) ARE obligated to fulfill their agreement, in one way or another. That is a significant component in the option world that we will explore next…

Mark's Tip
OK, that was just a high level introduction. To keep calls and puts straight in your head, just remember that a call option gives you the right to “call” a stock away from someone (think buy), and a put option allows you to “put” a stock to someone (think sell). In the next topic we will look at some real option pricing, trading and strategies.

Another Example

Returning back to the AAPL example, the stock is now trading at $130. Trader A thinks that the Price of AAPL is overvalued, (the price is too high) and it should come down in the next two months to around $125 a share. Trader B thinks that that the price of Apple will stay above $125 and will continue to go up.

Trader A will buy 1 put option contract (long put) on Apple with a strike price of $125 for $1.51, expiring in September 2021. This will cost $151, (1.51×100).

This is what it looks like:

If the price of the option drops below $125 before the expiration of contract; let’s say around $123. This option is “in the money” and the option is worth about $7.23. Trader A can turn around and sell the option to earn a profit of $572, ($723-$151).

Note: just like in the previous section, this is a very simplified example. The are other components would still apply, (volatility, interest rate, Dividend yield, etc.).

On the other hand, if the price did not go below $125 by the expiration date, then this option will expire worthless, and the trader A only lose the premium he paid ($151). When this happens, your options are “out of the money”.

Additionally, Trader B the seller of the same option who got paid the initial cost from the buyer ($151) will keep all the premium as a compensation for selling the right to the buyer of the put option.