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Put options are a type of option that increases in value as a stock falls. A put allows the owner to lock in a predetermined price to sell a specific stock, while put sellers agree to buy the stock at that price. The appeal of puts is that they can appreciate quickly on a small move in the stock price, and that feature makes them a favorite for traders who are looking to make a big gain quickly.

The other major kind of option is the call option. It’s the more well-known type of option, and its price appreciates as the stock goes up. (Here’s what you need to know about call options.)

How does a put option work?

A put option gives you the right, but not the obligation, to sell a stock at a specific price (known as the strike price) by a specific time, at the option’s expiration. For this right, the put buyer pays the seller a sum of money called a premium. Unlike stocks, which can exist indefinitely, an option will expire at expiration and then be settled, with some value remaining or completely worthless.

The major elements of an option are the following:

  • Strike price: The price at which you can buy the underlying stock
  • Premium: The price of the option, for either buyer or seller
  • Expiration: When the option expires and is settled

One option is called a contract, and each contract represents 100 shares of the underlying stock. Contracts are priced in terms of the value per share, rather than the total value of the contract. For instance, if the exchange prices an option at $1.50, then the cost to buy the contract is $150, or (100 shares * 1 contract * $1.50).

Put options are in the money when the stock price is below the strike price at expiration. The put owner may exercise the option, selling the stock at the strike price. Or the owner can sell the put option to another buyer at fair market value.

A put owner profits when the premium paid is lower than the difference between the strike price and stock price. Imagine a trader purchased a put option for $0.80 with a strike price of $30 and the stock is $25 at expiration. The option is worth $5 and the trader has made a profit of $4.20.

If the stock price is above the strike price at expiration, the put is out of the money and expires worthless. The put seller keeps any premium received for the option.

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Why buy a put option?

Traders buy a put option to magnify the profit from a stock’s decline. For a small upfront cost, a trader can profit from stock prices below the strike price until the option expires. By buying a put, you usually expect the stock price to fall before the option expires. It can be useful to think of buying puts as a form of insurance against a stock decline. If it does fall below the strike price, you’ll earn money from the “insurance.”

Imagine that a stock named WXY is trading at $40 per share. You can buy a put on the stock with a $40 strike price for $3 with an expiration in six months. One contract costs $300, or (100 shares * 1 contract * $3).

Here’s the buyer’s profit when the option expires.

As you can see, below the strike price the option increases in value by $100 for every $1 move in the stock price. As the stock moves from $36 to $35 – a decline of just 2.8 percent – the option increases in value from $100 to $200, or 100 percent.

The option may be in the money – below the strike price – at expiration, but that doesn’t mean the buyer has made a profit. Here the premium costs $3 per share, so the put buyer doesn’t start earning a profit until the stock reaches $37, at the $40 strike price minus the $3 premium. So in this example, $37 is the breakeven point on the trade.

If the stock finishes between $37 and $40 per share at expiration, the put option will have some value left on it, but the trader will lose money overall. And above $40 per share, the put expires worthless and the buyer loses the entire investment.

Buying puts is appealing to traders who expect a stock to decline, and puts magnify that decline even further. So for the same initial investment, a trader can actually earn much more money than short-selling a stock, another technique for making money on a stock’s decline. For example, with the same initial $300, a trader could short 10 shares of the stock or buy one put.

If the stock finishes at $35, then…

  • The short-seller makes a profit of $50, or ($5 decline * 10 shares).
  • The options trader makes a profit of $200, or the $500 option value (100 shares * 1 contract * $5 decline) minus the $300 premium paid for the put.

Percentage-wise, the short-seller earns 16.6% percent while the option returns 66 percent.

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Why sell a put option?

If you’re looking to trade options, you can sell them as well as buy them. Here are the advantages of selling puts. The payoff for put sellers is exactly the reverse of those for buyers. Sellers expect the stock to stay flat or rise above the strike price, making the put worthless.

Using the same example as before, imagine that stock WXY is trading at $40 per share. You can sell a put on the stock with a $40 strike price for $3 with an expiration in six months. One contract gives you $300, or (100 shares * 1 contract * $3).

Here’s the seller’s profit at expiration.

As you can see, the profit for the put seller is exactly the inverse of that for the put buyer.

  • For a stock price above $40 per share, the option expires worthless and the put seller keeps the full value of the premium, $300.
  • Between $37 and $40, the put is in the money and the put seller earns some of the premium, but not the full amount.
  • Below $37, the put seller begins to lose money beyond the $300 premium received.

The appeal of selling puts is that you receive cash upfront and may not ever have to buy the stock at the strike price. If the stock rises above the strike by expiration, you’ll make money. But you won’t be able to multiply your money as you would by buying puts. As a put seller, your gain is capped at the premium you receive upfront.

Selling a put seems like a low-risk proposition – and it often is – but if the stock really plummets, then you’ll be on the hook to buy it at the much higher strike price. And you’ll need the money in your brokerage account to do that. Typically investors keep enough cash, or at least enough margin capacity, in their account to cover the cost of stock, if the stock is put to them.

For example, if the stock fell from $40 to $20, a put seller would have a net loss of $1,700, or the $2,000 value of the option minus the $300 premium received. But done prudently, selling puts can be an effective strategy to generate cash, especially on stocks that you wouldn’t mind owning if they fell.

Bottom line

Many people think options are highly risky, and they can be, if they’re used incorrectly. But investors can also use options in a way that limits their risk while still allowing for profit on the rise or fall of a stock.

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