What are put options?
In their simplest form, put options are contracts to buy or sell a specific stock at a set price for a specific amount of time. The four components that are crucial to an options contract are an agreement to buy or sell a stock, a price that has been agreed upon, for how long this agreement is, and finally, and what the strike price is. With all these four components in place, you have an options contract. In a put option contract, the owner gets the right but not the obligation to sell a specified amount of an underlying security at a specified price within a specified time. The opposite of this happens in a call option, where the holder gets the right to buy shares.
Buying and selling put options
In the options market, you can both buy and sell put options. In the options market parlance, selling put options is also known as ‘writing’ options. When you buy a put, you pay a premium. A long put option position typically increases in value when the price of the underlying stock depreciates relative to the strike price. On the other hand, the value of a put option decreases if the price of the underlying stock increases as you come closer to the time of the expiration of the contract. Owning a put is a bearish position because you can make money if the price of the stock goes down.
It may seem counterintuitive that you can make money when the value of the stock goes down but that is the entire fun of the put option. When the stock price goes down, the option price has to increase. Hence, owning a put option is a bearish position because you are forecasting that the stock’s price will fall in value before the expiration date of the put. That causes the put to be worth more and it gives you ability as the owner of the option to sell the stock at a set price. On the other hand, if the stock is trading at a higher price, that option is not going to be worth very much and you can, instead, sell the stock in the stock market.
Selling a put option is taking exactly the opposite position of a buy option and it is a bullish position because you would want the price of the stock to go up. However, it is not necessary that the stock price should go up for you to make a profit. All you want is that this option should not be worth anything on expiration and, for that to happen, the stock price has to stay above the strike price of the option. In a buy put, your risk is limited to the amount you paid for the put option.
Further, in both buy and sell options, you do not have to wait until the expiration of the contract. You can make money throughout the cycle. The markets are dynamic, prices are constantly changing, and you can profit from the increase in price at any point until the expiration of the contract. That is how the options markets work. You make money when you sell options by buying back when the value goes down or, if everything works out perfectly as planned, at expiration, the option is ‘out of the money’; it is worthless, and you make money.
Profiting from a rise and a fall
You can choose to buy or sell put options depending on your strategy. Whatever be the case, you can profit around the cycle from your investment until the expiration of the contract. With a little more understanding of how calls and puts work, you can turn the odds in your favour and increase the consistency of your returns.