Introduction
Put options are a right to sell a security at a specified price until a specified date. Options give you the right to “put the security”. The put option on the security is determined by a contract. Typically, the securities are stocks but can also be commodity contracts or currencies.
Buying
When you buy a put option, you are guaranteed not to lose more than what you paid as a fee to purchase that option. You pay a small fee to the person who is willing to buy your shares.
The fee covers their risk. After all, they realize that you can ask them to buy it on any day during the agreed-upon period. They also understand that there is a possibility that the stock’s value could be much lower on that day. But they believe it is worth it because they think the stock price will rise. Like an insurance company, they prefer to have the fees that give them a slight chance of buying the stock in return.
Long buy: If you buy an option without owning the stock, this is known as a long buy. Protective buy: If you buy an option on a stock you already own, this is known as a protective buy. You can also buy an option for a portfolio of stocks or an exchange-traded fund (ETF). This is known as “index put protection.”
Selling
When you sell a put option, you agree to buy a share at an agreed-upon price.
Put option sellers lose money if the stock price drops. This is because they have to buy the stock at the strike price but can sell it at a lower price. They profit if the stock price rises because the buyer will not exercise the option. Option sellers collect the fees.
Option sellers stay in the business by writing many options on stocks they believe will rise in value. They hope that the fees they collect will offset the sporadic losses they incur when stock prices decline.
An option seller can exit the agreement at any time by buying the same option from someone else. If the fee for the new option is less than what they received for the old option, they gain the difference. They will only do this if they believe the trade is going against them.
Some traders sell options on stocks they would like to own because they believe they are currently undervalued. They are happy to buy the stock at the current price because they believe it will rise again in the future. Since the buyer of the option pays them the fee, they get to buy the stock at a discount.
Cash-secured put selling: You keep enough cash in your account to buy the stock or cover the option. Naked put selling: This is when you sell an unprotected option. This options strategy is not cash-covered but margin-covered.
Example Using Commodities
Put options are used for commodities as well as stocks. Commodities are tangible items such as gold, oil, and agricultural products including wheat, corn, and frozen meat. Unlike stocks, commodities are not bought and sold directly. No investor or trader buys and owns “pork”.
Instead, commodities are purchased in the form of futures contracts. These contracts are risky as they can expose you to unlimited losses. Why? Unlike stocks, you cannot just buy one ounce of gold. One gold contract equals 100 ounces of gold. If gold loses one dollar per ounce the day after you buy the contract, you’ve just lost 100 dollars. As the contract ends in the future, you could lose hundreds or thousands of dollars by the contract’s expiration date.
Put options are used in commodity trading as they provide a lower-risk way to engage in these risky futures contracts. In commodities, a put option gives you the right to sell a futures contract on the underlying commodity. When purchasing a put option, your risk is limited to the price you paid for the put option (known as the premium) plus any commissions and fees.
Even
To reduce risks, most traders do not exercise put options. Instead, they close them before expiration. They use them as insurance against losses.
Frequently Asked Questions (FAQs)
What happens when a put option expires?
If a put option expires before it is exercised, it essentially disappears. The brokerage will remove that option from the account of the person who purchased the option. The person who sold the option will no longer need to worry about maintaining the buying power to purchase the stock. You should keep in mind that brokers may automatically exercise options on the expiration date if they are in the money (ITM), so ITM options are unlikely to expire.
What happens when you exercise a put option?
When you exercise a put option, you will sell 100 shares to the put option seller. If you do not own the shares before exercising the option, you will need the buying power to cover that purchase, even if you will only own the shares for a few minutes.
How do you close a put option?
If you sold the option to open a trade, you will buy the option at the current market price to close it. If you originally purchased the put option, you will sell it to close the trade. The expiration date or exercising of the option will also close the trade for both parties involved.
When should you buy a put option?
Generally, you want to buy a put option when you have negative feelings about the safety of something. In other words, buy put options when you believe the stock price will fall. Some traders use put options to hedge other positions they hold. For example, if someone has a large ownership in Apple, they may want to buy a put option on Apple so they don’t lose everything if Apple collapses.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
U.S. Securities and Exchange Commission. “Investor Bulletin: Introduction to Options.”
CME Group. “Overview of Gold.”
Original article by:
Kimberly Amadeo
Updated on:
April 4, 2022
Reviewed by:
Akhilesh Ganti
Fact-checked by:
Daniel Rathburn
Daniel Rathburn is an associate editor at The Balance. He has over three years of experience working in print and digital media as a fact-checker and editor. Daniel holds a bachelor’s degree in English and Political Science from Michigan State University.
Source: https://www.thebalancemoney.com/what-is-a-put-option-long-short-buy-sell-example-3305880
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