What is a Put Option?
A put is an options contract granting its owner the right, but not the obligation, to sell a specified quantity of an underlying asset at a defined price within a set period. An investor purchases a put with the expectation that the price of the underlying stock will drop below the set exercise price before the option expires.
Key Features of Put Options
- A put option allows the holder to sell the underlying stock at a predetermined price within a set time frame.
- The value of a put option increases as the underlying stock price declines, and decreases as the stock price rises.
- Investors purchasing a put typically anticipate a decrease in the stock price.
The Basics of Put Options
Put options are tradable across a variety of assets, including stocks, currencies, commodities, bonds, futures, and indexes. The buyer can exercise the underlying asset at a predefined strike price.
The value of a put option rises as the price of the underlying asset falls below the strike price. Conversely, the value decreases as the underlying asset’s price rises. The put option’s value also depreciates as its expiration date nears due to time decay.
Because put options provide a short position when exercised, they are commonly used for hedging or speculating on price drops. An important strategy utilizing put options is a protective put, often used to mitigate potential losses.
Generally, as expiration approaches, the put option’s value decreases since the likelihood of the underlying stock falling below the strike price reduces.
Intrinsic Value vs. Time Value:
- Intrinsic Value: The difference between the strike price and the current stock price if in the money (ITM).
- Time Value: Significantly decreases over time, especially as the expiration date closes in.
Out-of-the-money (OTM) and at-the-money (ATM) puts hold no intrinsic value, as exercising them wouldn’t provide a benefit over selling at the current market price.
Puts vs. Calls: The Core Distinction
Derivatives include financial instruments deriving their value from underlying assets like commodities or stocks. The prominent stock options are put and call options.
A call option enables the holder to buy the underlying asset at a future date and price. Contrastly, a put option allows an investor to sell the asset at a future date and price. Holders of put options anticipate the stock price will drop, potentially yielding a profit by selling the put in the open market or exercising it to sell the asset at the strike price.
Real-World Example: How Does a Put Option Work?
An investor acquires a put option contract for ABC Corporation at $100. Each contract represents 100 shares, with a $10 strike price and an ABC stock price currently at $12.
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If ABC’s share price plunges to $8, the put is in-the-money (ITM), and the investor can either sell the put option or exercise their right, purchasing ABC shares at the market price and selling them at the higher $10 strike price.
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The initially paid $100 premium would be subtracted from the profit to determine the net gain.
Additionally, a put option can serve as a hedge if the investor already owns 100 ABC shares, referred to as a married put. This can help mitigate the losses if the share price drops.
Related Terms: call options, short selling, strike price, derivatives, protective put.
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- Schwab. “Theta Decay in Options Trading”.
- TD Ameritrade. “Options Refresher: Basics of Call and Put Strategies”.
