Understanding Put Options: Risks and Strategies of Using Put Options (2024)

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• Put options are contracts that allow investors to sell a specific number of securities at a predetermined price within a specified timeframe.
• They are bought when a trader expects the option's underlying asset to fall.
• Brokerage firms typically require that investors apply and be approved to buy options to execute put options.

The stock market is unpredictable, and even the most dedicated Wall Street enthusiasts aren't fortune tellers. But that doesn't stop some investors from attempting to prophesy the next market crash. In 2016, some predicted that there could be a 50% drop in the market. In 2017, legendary investor Jim Rogers predicted we would see the "worst crash in our lifetime."

Neither of those predictions turned out to be nearly as bleak. But that didn't make any of those economic setbacks any less painful. Still, most investors know that the stock market goes through expansion and contraction phases.

But what if there was a way to make money even when the market falls? This is where put options for income generation come into play.

Here's how buying and selling put options works and some of the risks involved.

What is a put option?

A put option is a contract that gives the owner the right (but not the obligation) to sell an asset at a predetermined price. The predetermined price is known as the strike price.

Those who buy put option contracts are betting that the asset's price will fall, somewhat similar to short-selling stock. Some investors prefer to buy puts on certain assets rather than shorting a stock since put options are potentially more profitable. The further the underlying asset's price falls, the more valuable the option contract can become.

"In short, options contracts allow you to profit from renting stock without actually owning the shares," says Cassandra Cummings, RIA and founder of the Stocks & Stilettos Society.

How do put options work?

Each put option contract represents 100 shares of the underlying asset, but investors don't need to own the stock to buy or sell a put.

Put options become more valuable as the underlying stock's price falls and loses value when the stock's price rises. Generally, the value of a put option can also decrease as it approaches the expiration date. This is known as time decay; Cummings suggests purchasing contracts that go out at least 45-60 days to minimize this.

The process of determining the profitability of an option is found using intrinsic value, which is calculated for a put option by subtracting the underlying asset's price from the strike price. For example, the strike price was $100, and the current price is $80. This makes the intrinsic value $20.

Buying put options

Put options are more complex than buying and selling stocks or index funds. In most cases, brokerage firms require that investors apply and be approved to buy options.You may also be asked to provide your annual income and net worth. Generally, within a few business days, your account will be approved (or denied) for certain levels of option trading strategies.

If the account is approved, you can buy put options in your account — just keep in mind that certain put option trading techniques are not allowed within IRAs. Option trading levels range from Level 1 to Level 5, with Level 5 being the most complex.

Whendoing a put options transaction, you'll need to take into account the underlying security associated with the option, the options strategy (in the case, a put option), the expiration date, the strike price, the cost of the option (the premium), and the order type (market order or limit order).

When an option is purchased, the buyer pays a premium: the maximum amount that the option buyer can lose in a trade. This is because options have an expiration date. The contract will become worthless if the put is not traded or exercised by the expiration date.

Put options are available for assets, such as:

• Stocks
• ETFs
• Index funds
• Commodities
• Currencies

Selling put options

Remember that buying a put option differs from selling a put option. Selling a put means that you will receive the premium as income. Risks of selling put options include being forced to buy the shares of the underlying stock if the price falls below the strike price.

Put sellers typically expect the option's underlying stock to increase in value or stay the same. Sellers are obligated to buy the option from the put buyer at the strike price, with either cash in their account or on margin. If the company trades below the strike price, the option is trading "in-the-money "(ITM). This is because the option holder would see a profit if the option was exercised.

Out-of-the-money (OTM) is the opposite, meaning the stock's current price is above the strike price. Put sellers earn the premium when the stock stays the same price or increases. Sellers are then able to make another put option to increase earnings.

Finally, you have a put option that can be "at-the-money" (ATM), meaning the stock's current price is very close to or equal to the strike price.

Example of a put option

After doing some research, let's say that you have concluded that shares of ABC company will fall below $100 per share, which is where our fictional company is currently trading. By purchasing a put option for $5, you can sell 100 shares at $100 per share.

Put options vs. call options

Think of put options and call options as two sides of the same coin with their respective characteristics essentially inverted.

Investors who feel a stock will rise may purchase a call option. They may choose a put option if they feel the price will fall. One common refrain to help you remember this is "call up and put down."

Risks and benefits of trading put options

Put options can be a good way to protect against downside risk if the market falls but they also come with added risks and complexity. Unlike trading a stock, speculative trading with put options requires the investor to be right about the underlying asset, the direction, and the timing since all options contracts have an expiration date.

"Risk management is also important," says Cummings, "Many new investors avoid risk management techniques such as entering trailing stop loss orders to lock in profit on the upside and protect their premium on the downside."

Remember to consider the time frame of when your put option expires and the strike price. Riskier put options are generally more expensive, and options with higher strike prices often offer greater price protection. Also, try to have the purchase price of the put be as close or equal to the expected downside risk of the underlying security.

Put options can also be used as a hedging strategy to reduce risk in your investment portfolio. Although risky, hedging strategies using put options offer a way for investors to limit potential loss. When done right, put options act as an effective hedge, especially for long puts.

Put options FAQs