A put option is a contract that entitles the owner to sell a specific security, usually a stock, by a set date at a set price. The owner can either exercise the contract or allow it to expire, hence the term “option.” Options themselves are not a true security but rather a type of financial derivative, in that their value is derived from that of another asset. They can be bought and sold like stocks on derivatives exchanges and over the counter by financial institutions.
The mirror opposite of a put option is a call option, which gives the holder the right but not the obligation to buy a security at a set time at a set price. Both types of options allow the parties on each side of the trade to either take what's called a “long” position (betting on the possibility the stock will rise), or to take a “short” position (betting that it will fall).
In the case of a put option, the writer (i.e. the seller) is speculating that the stock will exceed expectations and the buyer is taking the chance it will underperform. This is not the same as short selling, in which an investor sells borrowed shares with the obligation to buy them back later to cover the position. But it presents another, potentially less risky way to take the bearish side in a trade because your losses are limited to the premium you paid for the put option vs. if you had sold the stock short your losses are in theory infinite, as the stock can go up indefinitely and you would be forced to buy back the shares at these prices.
To trade in options, you must have a brokerage account and upgrade to options trading functionality.
TD Direct Investing clients can apply for four different levels of options trading, according to the type of account. Approval is tied to the client’s investing knowledge, income and account size.
Put options are usually bought and sold in blocks corresponding to the right to sell 100 shares of the underlying asset, though the premium is expressed on a per-share basis.
Until the put option expires, it has a value. For example, if the strike price is $50 and the stock is trading for $45, its intrinsic value is $5. If exercised immediately, the holder will have profited $5 per share minus the premium they paid for the option. If a week passes and the stock rises to $47, the option's value will shrink. If the stock is trading above the strike price, the option is “out of the money” and its value will be negligible, based only on the remaining duration of the option and the odds the stock sinks below the strike price in that time frame.
Short-term options of less than a year are typically written in anticipation of an event that could affect the stock’s price. For example, if you write a put option, then you are hoping that the stock price will continue to trade flat, go up or trade sideways. If you sell a call option, you are hoping the stock price will continue to trade flat, go down or trade sideways. In either case, you can expect to collect the option premium. Long-term options of more than a year are often used to speculate on the stock’s possible decline. They tend to come at a higher premium owing to the longer period the stock has to dip below the strike price. The intrinsic value plus the duration of the option equals the value reflected in the premium.
When an investor or institution writes a put option, they are essentially offering to buy a certain number of shares in a particular company by a certain date for a certain price. Although the option may change hands multiple times, it’s the writer who remains responsible to fulfill the contract and buy the stock. Writing options provide the writer with a source of revenue for taking on what they consider an acceptable risk. It also gives them a means to accumulate a position in a stock they like and think has a higher intrinsic value than the current market price.
Advantages: Put option spread strategies help investors manage risk. Another part of their appeal is that they are market-neutral: You can make money whether the stock market is going up or down. But options strategies can be complex and are not for every investor.
Risks: A writer of naked puts risks losing up to 100% of the value of stocks that decline toward zero. Otherwise, the risks are foreseeable. A buyer of a put option risks only losing the value of the premium they paid should the option expire unused.
Two examples of put option strategies
Why would you buy a put option?
To manage portfolio risk. If the put option's underlying stock goes down, you can sell that company at the value denoted on the option, known as the strike price. This way, you can limit losses or lock in gains on a holding. It sets a floor for the stock’s value up until the expiry date.
How do put options work?
They give the holder the right, but not the obligation, to sell the stock for a pre-agreed price.
How does the value of a put option increase?
The holder — or buyer — of the option profits when the stock price declines below the strike price before the expiration date. The writer — or seller — of the put makes money from the premium the buyer pays to purchase the option.
How does a put option decrease in value?
One reason the put's intrinsic value is decreasing would be because the stock is rising toward the strike price.
What is a put spread?
There are multiple strategies for playing puts, such as buying and selling puts on the same stock at the same time, known as a put spread.
What happens if a put option is not sold?
If the option expires without being sold or exercised it is then worthless.
What happens if a put option is sold?
If you are the writer (or seller) of the put option, you may be required to buy the underlying shares at the price set. If you are the buyer (or holder) of the put option and you sell it to another buyer, you have no further rights or responsibilities with respect to the contract terms.
