What are put options?

How do put options work?

Put options work through an agreement between a buyer and a seller to exchange an underlying asset at a specific price by a set expiration date. You’ll often buy put options when you anticipate a significant drop in the underlying asset's price or an increase in implied volatility (IV) before the option expires. The setup of put options involves several key aspects:

There are three primary ways to settle long options contracts:

1. Exercise the option if it's in the money (ITM)

2. Sell the contract before expiry

3. Allow the option to expire worthless if it remains out of the money (OTM)

For short put options:

1. Be assigned if the option is exercised when it’s ITM

2. Buy back the contract before expiry

3. Let the option expire OTM, keeping the premium

The pricing of put options

Before we can get into buying and selling put options, it's helpful to know a bit more about how they're priced and what affects their value. Two main factors influence an option's price:

1. Intrinsic value: this is the amount by which an option is in the money. For a put option, it’s the difference between the strike price and the asset’s current price (if the asset’s price is below the strike price)

2. Extrinsic value (or time value): this is any additional value above the intrinsic value, based on the time left until expiration and the asset’s volatility

As the expiration date approaches, the extrinsic value decreases – also known as time decay. This is why options are often described as wasting assets.

Buying a put

Buying a put option, also known as going long on a put, is generally associated with a bearish market outlook. To profit from a long put position, the underlying asset's price needs to move significantly downward, crossing below the put's strike price before or on the expiration date.

Example:

Let’s say Tesla’s stock price is on the verge of dropping substantially. With its current price at $100, you think it’ll drop below $75 in the near term.

Suppose you buy a 45-day put option on Tesla stock with a strike price of $75 and a premium of $2 per share ($200 total for the contract). If the stock price falls below $73 (strike price minus the premium) by the expiration date, you can sell the contract at a higher premium for a net profit.

Even if the stock doesn't fall below the strike price, the put's value can increase if there's a sharp bearish move with ample time left before expiration. For instance, if the stock price drops to $65, you could potentially sell the contract for $10 intrinsic value ($75 - $65) plus any remaining extrinsic value.

If there's $1 of extrinsic value left, you could sell the contract for $11 per share ($1,100 total), resulting in a $900 profit ($1,100 - $200 initial premium).

A long put option can be closed in one of three ways:

1. Let it expire out of the money (OTM) and worthless, forfeiting the premium paid

2. Sell the put option for a profit in the money (ITM), or loss (if OTM) before expiration

3. Exercise the put and short 100 shares of the underlying asset (if ITM)

Selling a put

Selling put options, also known as writing puts or going short on puts, involves a neutral to bullish market outlook. Put sellers aim for the underlying asset's price to remain above the strike price, allowing them to keep the premium collected upfront as profit if the option expires out of the money.

Puts vs calls: what's the difference?

Put options and call options are like two sides of the same coin. Understanding the differences between them is crucial for any options trader.