The Importance of Put Options
Put options play a significant role in the investment strategies of many traders. Here’s our guide to what they are and how to utilize them.
What is a Put Option?
A put option is also commonly referred to as a ‘put’. This is a type of contract that gives the option buyer the right to sell, or sell short, a certain amount of securities at a predetermined price and within a time frame of their choosing. Put options create flexibility through offering a secured, guaranteed window to execute a sale, without the obligation for the seller to do so.
Put options are used across a wide range of asset types, including stocks, bonds, futures, indexes, currencies, and commodities.
How Does A Put Option Work?
Put options grow in value in direct correlation to the decreasing price of the underlying stock or security. Should the underlying stock increase in price, a put option begins to lose its value. Put options are sometimes used by investors as a hedging strategy, allowing them to make the most of a potential reduction in price value.
Major Elements of A Put Option
Looking to use put options in your investment strategy? Here are the major elements of how put options work.
A strike price is the predetermined price at which the buyer of the put option can sell the underlying security. Its value is defined by the difference between the fixed strike price and the current market price of the security. This is referred to as the option’s ‘moneyness’.
A put option’s premium reflects the time value, or the extrinsic value. This reflects the amount the buyer of an option pays to the seller for the right to use the option, but not the obligation to do so. If an option is ‘in-the-money’, it will have a higher premium, with the premium increasing as the amount an option is ‘in-the-money’ increases. Premiums decrease as the difference between the strike and the underlying price becomes larger.
As a put option gets closer to expiration, its value begins to decrease as a result of time decay. With less time to realize a potential profit from the trade, time decay continues to accelerate as the expiration point draws closer.
Factors That Affect A Put's Price
There are a number of factors that impact the value of a put and its corresponding price. These include:
• Expiration - how close to expiry the put option is
• Out-of-the-money and at-the-money put options - these have no remaining value as there’s no benefit in utilising the option
• The put option’s profitability potential and its premium
Put Options vs Call Options
A call option is the inverse of a put option, giving the holder the right to buy an underlying security at a defined price either on or before the expiration date of the option contract. Call options are another form of financial contract that creates rights, but not obligations. Call buyers realize a profit when the asset that’s underlying within the call option increases in price.
Buyers need to pay a fee in order to purchase a call option (the premium). They’re often purchased for speculation and are also sold by call option holders in order to manage tax implications, or for income purposes. It’s also common for call options to be combined within an overall combination strategy.
Put options vs Short selling
While you may recognize some similarities between put options and short selling, in that both are forms of bearish strategies, there are a number of key differences that make these two strategies distinct.
In a put option scenario, the buyer’s maximum potential loss is limited to the premium they paid for the put. Buying puts also doesn’t require a margin account, opening up access to put options to those without significant amounts of capital. By comparison, short selling has open-ended, potentially unlimited risk, dependent on market movements entirely outside the investor’s control. It’s also more expensive, incurring more costs such as stock borrowing charges and margin interest. Put options are viewed as a safer option than short selling, offering a safer alternative to investors looking to hedge their investments.
Buying and Selling Put Options: Strategies and Examples
Investors who are entering the put option market, whether on the buying or selling place, need to ensure they’ve considered the many variables involved in securing the exact option they’re looking to purchase. With many different choices involved in option security, specificity is key to building out a put option investment strategy. Investors need to define:
• Which stock they’re associating with the option as the underlying security
• Whether it’s a put or a call option strategy
• The option’s expiration date
• The strike price
• The premium
• The order type (market order vs. limit order)
A protective put is a type of investment insurance (or hedge) that looks to ensure any losses across the underlying asset does not exceed a specified amount. Within a protective put, investors place put options that are designed to hedge their downside risk in an individual stock. If the option is exercised, the investor then sells the stock at that strike price. Investors can also create a short position, by exercising a put option when they don’t hold the underlying stock. However, if investors buy a put and the stock price rises, the cost of the premium will reduce the profits on the trade. And if the stock declines in price and a put has been purchased, they may lose the premium on the trade.
This options trading strategy sees investors buying and selling the same amount of put options in parallel, thereby hedging their positions. But there's still a potential risk of losing the premium.
Bull put spreads
A bull put spread is a strategy undertaken by options investors who write puts on stocks to collect premium incomes, potentially then buying the stock at a heavily reduced price. This strategy isn’t without its risk, with the investor obligated to buy the stock at the put strike price, even if the stock value continues to fall below this price (thereby guaranteeing the investor a loss). However, this strategy is used by investors to try and mitigate the risk of put writing through the parallel purchase of a put at a lower price, reducing both the net premium and the risk of a short put position.
Bear put spreads
In contrast to a bull put spread, a bearish put spread sees an investor purchase a put contract with a higher strike price while also selling a put option at a slightly lower strike price. If the underlying share price decreases, the investor stands to make a profit. If it increases, however, losses are limited through the sale of a put option that offsets the newly created put contract.
A naked put refers to put contracts that are sold without an offsetting position. Sellers of naked puts stand to profit from the options contract in association with a price rise in the underlying stock. However, this strategy also comes with substantial risk, as the stock price can continue to fall, therefore causing the seller to have to purchase a decreased stock at the predetermined strike price.
Implied Volatility in Long Calls
Implied volatility refers to the forecasted magnitude of potential movement away from the underlying price over the course of a year. While this isn’t a guaranteed metric, investors can use implied volatility to analyse ranges from a statistical viewpoint, informing their risk management strategies. A low level of implied volatility speaks to a market belief that the stock price isn’t expected to fluctuate much over the course of a year. On the other end of the scale, a high implied volatility environment demonstrates a market belief in significant price movements over the period of the next twelve months.
A high level of implied volatility means that investors who are bearish on a particular stock may choose to purchase puts based on a ‘buy high, sell higher’ investment belief.
Buying a Put Option (Long Put)
Buying a put option can act as an insurance policy for your stock portfolio, protecting your long-term investments through hedging.
When to Close a Long Put Option
Buyers have multiple options when it comes to exiting a long put option. A sell-to-close (STC) order can be entered anytime before expiration, actioning the sale of the contract. The premium collected from this sale will then be returned to the seller.
Long put options can also be managed across their lifetime to minimize risk. If stock prices rise, a put option can be executed at a lower strike rate to reduce the risk of the trade, giving the owner of the put option multiple options when it comes to long-term investment management.
In-the-money defines an option that possesses intrinsic value, representing a profit opportunity between the strike price and the market price of the underlying asset.
Out-of-the-money describes an option that only contains extrinsic value, not intrinsic value. In this instance, an OTM call option has a strike price that’s higher than the market price of the underlying asset.
Selling Put Options (Short Put)
Short puts occur when an investor opens an options trade through selling or writing a put option. The writer of the put option receives the premium, with the profit on the trade limited to that amount.
Advantages of trading with Put options
Trading with put options offers the potential to realize significant advantages. As with any investment strategy, they can also represent inherent risk, requiring foundational knowledge of the advantages and risks of put options before any investment strategy is executed.
Limit risk-taking while generating a capital gain
Put options can be used by investors to limit their exposure to risk while still generating a capital gain. While short-sellers can represent opportunities for capital gains, they’re inherently more risky in their points of difference for traders.
Generate income from the premium
Investors have the capacity to sell options in order to generate income, which can give the advantage of incremental returns.
Realize more attractive buy prices
Options can allow investors to achieve better buy prices on their stocks, enabling them to sell puts on stocks they’d like to secure. Should that price fall below the put’s strike, they can then exercise the option, discounting the premium on their purchase.
Risks of buying and selling put options
Buying and selling put options can also come with risks. If the market moves in an adverse direction and there’s no hedge or exit strategy in place, this can have a significantly detrimental impact on the investor’s profit potential (or loss). During the sale of a put, risk arises through falling stocks, with put sellers obligated to buy a stock even if its price falls lower than the put’s strike price.
When should you buy or sell put options?
The right time to buy or sell put options depends on many individual factors. For any investors looking to enter the put option market, they’re advised to build a robust understanding of the risks and advantages of the strategy, tailoring a buying or selling approach that’s informed by their individual investment appetite and desired outcomes.