You’ve probably have asked yourself what are put options in the stock market, or how do put options work?
A put option is an option contract in which the holder or buyer has the right but not the obligation to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its (expiration).
In contrast, the writer of the put option has the obligation to purchase the the underlying security if the option is exercised by the buyer. This typically happens if the stock price is at-the-money (ATM) or in-the-money (ITM). The writer is paid a premium for the associated risk on possibly taking on the obligation.
Example: If you write or sell PUT options or 1 put option on Amazon for $600 at the 1776 strike price and Amazon is currently at 1890, the full $600 is paid to you as the writer. If the stock does not drop before or at expiration to 1776, you keep the $600 profit. If the stock does drop, and the buyer chooses to exercise the put option, then you are assigned 100 shares at 1776. (100 x 1776 = $177,600) less the $600 that was paid to you.
How Do Put Options Work
As we understand what a put option is, and what are put options in the stock market, we will know why buy put options and how put options fully function in terms of traders or investor needs. As an option seller, you have the obligation to purchase the shares if the put options buyer has exercised the their contract or contracts.
Remember, 1 option contract is equal to 100 shares. So when buying or selling options, keep this in mind.
You also have time decay, or Theta on your side when selling options, or in this case selling put options. The buyer has time or Theta working against them. This is because options have an expiration.
Unlike shares, options eventually expire either with intrinsic value, or extrinsic and out of the money. and worthless.
Why Buy Put Options
The reason investors or traders in the stock market want to buy put options is to secure their current position or shares that they own on a particular stock.
Put Options Example: If you own 100 shares of Under Armour, and think that the stock will drop after their earnings report. You would purchase 1 PUT Option. Depending on the price to which you bought your 100 shares, or the price you are willing to sell or let go of your shares, you would purchase the put option. This allows you to sell the 100 shares at the contracted price that you bought the put option for. If you bought 100 shares at 32 (32 x 100 = $3,200) and the current price is at 34 you could buy a put option at 33. This would allow you to sell your shares at 33 even if the stock drops to 16.
Buying put options is just like insurance on an asset. If the stock drops you have the right to sell the stock at the strike to which the option you bought, and the seller of the put option has the obligation to buy those shares for that strike price. Or, you can sell the contract for a higher price than you originally paid and keep your shares.
Scenario 1: You own a $40,000 vehicle. You go and buy an annual insurance policy. The vehicle is neither damaged or stolen, and the insurance seller (PUT Option Seller) has just collected your premium without any payouts. You’re happy to have just paid insurance for protection on your asset or vehicle (PUT Option Buyer).
Scenario 2: You are involved in an accident requiring $10,000 in repairs. You make a claim (exercises your put option) and the insurance pays you the claim. You’re happy you purchased protection for the loss or damage.
Scenario 3: You have a total loss claim or the vehicle gets stolen and again you exercise your put option. You get to have the full amount of your asset or vehicle at the $40,000 coverage. The PUT Option Seller pays you the full amount or in stock market scenario, they take ownership of your shares.
When To Buy Put Options
As you can see the benefits of buying PUT options allows you to lower your losses on a down market when you own shares. This is also called protective puts.
Of course you can just buy put options without owning shares but there is a much larger risk associated when doing so.
Buying put options is also in comparison to shorting the stock, but with less risk to the upside. Hence, when buying, the amount of total loss equals the amount to which you paid. If you are shorting shares, there is an unlimited amount of risk to the upside, as the stock could always go up to any amount.
The amount of profit potential when buying a PUT, is maxed if the stock reaches zero. The amount of profit when shorting shares, is only the amount you short.
On the flip side there is a strategy to selling put options that has much more benefits that buying put options and that can be covered in my eBook How to Create Cash Flow Without Owning Stock.
A secret to know when to buy put options is knowing when to first cover your assets, or shares that you own and believe that the stock price will drop. Also buying put options when implied volatility is low. A rise in implied volatility will cause the value of the option contract to rise and allow you to sell at a higher price than you bought the option for.
Of course there is more to buying and selling options than just looking at the implied volatility. All of that is covered in How To Treat Your Stocks Like Real Estate.
Why Sell Put Options
One of the best ways to profit without owning stock is knowing when to sell put options. Selling put options can both land you profits without owning or dealing with shares or it can hedge you into a position if you’re already looking at buying shares of a certain stock.
Example: If you’re already looking at buying 100 shares of Amazon, one of the best ways to pick up shares at a lower price all while picking up profits, is to sell a put option. Amazon is currently trading at 1776. Thus buying 100 shares would cost you $177,600. We would sell a put option at 1770 and depending on the price of the option and expiration it could allow you to profit before buying. If the price of the put option is $1,000 and expiration is 30 days out, then you could profit $1,000 without taking ownership if the price does not drop to 1770. If it does, then you would still take in the $1,000 and take over the 100 shares at $177,000 less the $1,000 equaling $176,000.
Remember that when dealing with stock options there is time decay (Theta) on all options. Buyers are affected by this Theta negatively, as their contracts are always decaying as time goes. Option sellers however benefit from time decay or Theta due to the option needing to expire worthless to capture and remain on the premium they sold.
Knowing when to buy and sell put options come with learning as you become more experienced.
My goal here at InvestingWithChris is to educate you the best way possible and to get you profiting sooner than it took me over the course of my investing and trading career.
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