Investors use the Put Option strategy when they are predicting a downward move of a certain stock price. That's because a put option gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime prior to the options expiration date.
If you buy a put option and the price of the stock goes down, you can sell the underlying stock shares to a buyer at a price higher than the market price. It's sort of like selling a Toyota for the price of a BMW. And even better, you don't actually have to own the stock to do it. You can simply sell the put before it expires and pocket the profit.
Trading a Put Option
The put buyer is bearish on the underlying security and is looking for a way to get leverage. There are two ways to play this.
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If you plan to hold the option until expiration day, then you will need the price of the underlying stock to decrease in excess of the option premium before expiration day. The buyer is typically looking for leverage.
- If you plan to hold the option short term in anticipation of a quick but more modest downward move in the underlying stock price. In that case, even though the stock price didn't move down as much as the options premium, you can quickly sell the option back to the market and make a potential profit.
Picking a Put Option
Just like the call, there are three variations of a put based upon where the strike price is relative to the current market price of the underlying security.
In the money: If a put option's strike price is above the current market price of a stock, it is considered to be in-the-money. The deeper in- the-money one goes, the higher the percentage of premium that will be in the form of intrinsic value — value that can be immediately converted into revenue on exercise. The time-value of the option will also diminish as the strikes go deeper in the money. The Delta of the option (the predicted percentage change of the price of the option relative to a one point change in the underlying stock) will be higher, reflecting a high probability that the position will make at least one penny of revenue at expiration (note: there is no guarantee that this forecast will be correct).
- There may not be much advantage to buying an option deep-in-the-money versus just shorting the stock — particularly with lower priced stocks.
At the money: If a put option's strike price is at the current market price of the stock, it is considered to be at-the-money. If you buy an at the money put option, then you only need the stock price to decrease by the option premium to turn a profit.
Out of the money: If a put option's strike price is below the current market price of a stock, it is considered to be out-of-the-money. The further out of the money one goes, the lower the options premium. Out of the money put options are typically the cheapest because the chance othat they will expire in the money is lower. In that sense, they give the investor higher leverage (it costs less to control 100 share of stock) but are more speculative.
- Buying too far out of the money is very speculative and has potentially higher rewards but much lower probability of success.
Do You Have to Own Shares to Profit From a Put?
The answer is "no". You have three ways you can realize a gain on a put — only two of which require you to sell shares:
- Sell the option on, or before, expiration day (most popular)
- Buy the shares and then exercise the long put (requires cash to buy the shares)
- Exercise the put, and establish a short stock position if your account allows it (considered risky)
How to Finish
At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss.
At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to purchase an equivalent number of shares in the marketplace, exercise the long put and then sell them to a put writer at the option's strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in your brokerage account.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.