Like any investment strategy, options trading is about finding a balance between risks and rewards.
At its simplest, an option is a contract linked to specific securities (e.g., stocks or bonds), granting you the right to buy or sell those securities on a particular date for a specific price.
The two basic contracts used in options trading are known as “puts” and “calls.” Today, we’ll be focusing on stock puts, showing you how they work and how you can buy and sell put options.
Put Options Explained
What is a put in stocks? Options, we noted, are contracts that grant the option to buy or sell a particular stock at a specific date for a set price.
The predetermined price is called the “strike price,” while the time during which the option is valid is known as the “expiration period.”
Put and call options guarantee two different sides of the same type of time-limited transaction:
- Put options allow owners to SELL a security for a fixed price
- Call options allow owners to BUY a security for a fixed price
How does this work? Imagine you own a put option on Stock X, which is currently trading at $250 per share.
Your option has a strike price of $200, expiring in one month. Let’s also assume that you paid a premium of $0.50, or $50 in total ($0.50 x 100 shares).
If shares of Stock X fall to $175 per share, you could buy 100 shares of Stock X from the market (100 x $175 = $17,500), and then sell these shares to the writer of your options for $200 each (100 x $200 = $20,000), which would yield a profit of $2,500.
To calculate your final net profit, you would simply subtract the price of your premiums ($50) from your subtotal to yield $2,450 ($2,500 – $50), though you may have some commission costs depending on your options broker.
So now that you’ve had put options explained, should you consider using them in place of short selling?
Stock Puts vs. Short Selling
As you can see from our above example, put options favor investors who believe a stock price is poised to decline. They offer a way of betting against the success of a company.
But options are not the only way to profit from common shares losing value. Some investors may be familiar with “short selling,” particularly as the practice made headlines in the recent GameStop fiasco.
In short selling, investors borrow the depreciating stock from their broker and sell it in the open market.
Then, once the stock price dips far enough, investors buy back the stock. The stock is then returned to the lender, and the profits from the sale (i.e., the difference between the buying and selling price) are pocketed by the investors.
Some pundits criticize this practice, and even the former head of the New York Stock Exchange calls it “icky” and “un-American.” Put options are considered more legitimate and have become attractive to investors since they pay out more than shorting a stock.
Advantages of a Put Option Explained
What is a put in stocks used for? Some investors use stock puts as a type of insurance policy on stocks they own. Buying a put option protects the buyer if the share price dips since the put option gains value when the stock declines in price.
This process is known as “hedging,” as in “hedging your bets.”
That’s not to say that other investors don’t simply use put options to bet against the success of companies, as this can be a more successful strategy (with greater profit potential) than merely shorting the stock.
When you buy put option contracts, you also gain the advantage of having more choices in investing and generating money.
When used as a hedging strategy, stock puts can help investors take greater risks (with the promise of greater rewards), creating new opportunities to invest in smaller, riskier startups.
How to Buy Put Option Contracts
Now that you understand stock puts fully, let’s talk about how you might go about buying a put option. To do so, you’ll need an options broker, though many standard stockbrokers will also allow you to purchase options directly.
The strike price is up to you. Normally, you would set the strike price below the current stock price. You can also choose your expiration date, and most investors choose expiration periods anywhere from a month to a year.
The longer the period, the lower your risk.
Each options contract is for 100 shares of stock. You decide how many options contracts you wish to buy. Each options contract will have a premium you have to pay, in addition to any brokerage fees.
The tricky part is monitoring stock prices to determine the best time to exercise your option. If share prices fall below your strike price, it’s considered to be “in the money.”
As in our example above, you can now require the writer of your option to purchase your shares at the higher strike price.
What happens if the share price never falls? You can simply let your option expire. Granted, you won’t gain any profit, but your losses will only be the cost of the contract plus any additional fees.
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