What is a put option?

In a nutshell

A put option is an investment tool investors can use to guarantee a profit on a security they’ve purchased, but only if that security drops in price during a period specified in the contract.

• Investors have the right, but not the obligation, to sell the stock at a previously agreed-upon price — regardless of the actual stock’s valuation — before the contract expires.
• As a result, investors can earn money on the value of a declining stock.

How does a put option work?

A holder of a put option gains when the price of the underlying security (often the shares of a company’s stock) drops and loses when the value increases.

A holder of a put option must first enter into a contract. The contract spells out the price at which a put option can be exercised (called the “strike price”), the length of the put option contract, and the premium the put option buyer will pay to the put option seller in exchange for granting the option. If the price falls below the strike price listed in the contract, the holder of the option can sell the stock to the seller.

For example, if the strike price is $50, and the price of the underlying stock falls to $40, the buyer can sell the stock to the seller for $50, and collect a profit of $10 per share. If the contract is for 100 shares, the buyer will receive a gain of $1,000, less the premium paid to the seller for the option. (The net gain will be reduced by the cost of the premium paid for the option.)

If the strike price is reached before the option expires, the seller is required to purchase the underlying securities. The holder of the option can also sell to another party, rather than waiting for the price of the stock to fall to the strike price. If the stock never falls below the strike price, the put option will expire and become worthless.

Put options pros and cons

Buying and selling put options

To engage in trading put options, you will need to have a self-directed investment account that permits options trading, such as J.P. Morgan Self-Directed Investing. (You will not be able to sell put options in roboadvisor accounts because these accounts are automatically managed.)

Put options are contracts with three major components:

1. Strike price: the price at which you can sell the underlying asset.
2. Expiration date: the date by which the option must be exercised, after which it expires and becomes worthless.
3. Premium: a fee paid by the buyer for entering into the contract. This is a cost to the buyer and revenue for the seller. The premium is multiplied by the number of shares in the contract in order to arrive at the total premium cost.

Put option premiums can vary based on several factors, including the price of the underlying stock relative to the strike price (as of the date the contract is written), the length of the contract, and the expected volatility of the underlying security.

Options trading also involves broker fees. Unlike stocks and exchange-traded funds, which commonly trade commission-free, brokers charge a fee per option contract.

Buying a put option

An investor may buy a put option if they believe the price of a stock is likely to decline in value. By contrast, an investor might sell a put option if they believe the price of the stock is likely to rise in value.

If the stock price does decline, the buyer stands to gain. However, any loss will be limited by the premium paid. For example, if the buyer purchases a put option on a stock with a strike price of $50 and a premium of $5, the price of the stock must fall below $45 ($50–$5) before the buyer will realize a profit.

However, if the option expires and the stock never drops to the strike price of $50 (or below) and the buyer does not exercise the option, they will lose the premium paid. That will be 100 shares at $5 per share, or $500.

Selling a put option

The other party in a put option is the seller. Unlike the buyer, who has no obligation to exercise the option, the seller (also called the writer) is required to buy the stock from the option buyer if the buyer chooses to exercise the option.

The buyer has a maximum loss potential equal to the amount of the premium paid, and potential gains up to the full value of the stock. (For example, 100 shares multiplied by the strike price: 100 x $50, or $5,000.)

The seller’s maximum gain is limited to the premium received on the option, while the potential loss could be as high as the full value of the $5,000 stock position.

One advantage of selling a put option is collecting the premium if the contract expires without being exercised. The potential loss for a put option seller is great, so the seller should be reasonably certain the stock price will rise — and the contract will expire — without being exercised.

Example of a put option

If an investor expects the price of a certain stock to fall, they might decide to buy a put option on that security.

Suppose the stock of XYZ Corporation is currently trading at $100 per share. The investor expects the price will fall enough to make a put option worth purchasing.

They buy a put option on the stock for 100 shares, with a strike price of $90, an expiration date of six months, and a premium of $5. When the premium is factored into the option, the price of the stock must fall to $85 before they will realize a profit.

Suppose three months later, the price of the stock falls to $75, and the investor chooses to exercise the option. They will sell 100 shares of the stock to the seller for a total price of $7,500.

They will earn a profit of $1,000: 100 x $90 = $9,000; $9,000 - $500 (premium) = $8,500; $8,500 – $7,500 = $1,000.

By contrast, if the stock price never falls below $90 during the six-month term of the contract, the option will expire and become worthless. The investor will lose the $500 premium payment, which will be a profit to the seller.

Put option vs. call option

While a put option is profitable for the buyer when the value of the security falls below the strike price, a call option is profitable for the buyer when the price rises above the strike price in the contract. The two options work similarly, but create profits in opposite directions.

For example, if an investor believed that stock in XYZ Corporation, currently trading at $100 per share, was likely to rise substantially, they may buy a call option for $110 with a premium of $3 per share.

If the price of the stock rises to $125 before the contract expires, and the buyer exercises the option to purchase, they’ll earn a profit of $1,200: 100 x $125 = $12,500; $12,500 – $11,000 = $1,500; $1,500 – $300 = $1,200.

However, if the stock price never reaches $110 during the term of the contract, the option will expire and become worthless. The investor will lose the $300 premium, and the seller will profit from the transaction because of the $300 premium they receive.

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Options trading is an advanced investment strategy, and you should not engage in the practice unless you have a comprehensive understanding of how it works and the risks.