The theory
A put gives the owner (buyer)
- the right (not the obligation)
- to sell the underlying (a given stock)
- at a given price (strike)
- before a given date (expiration date)
- In exchange, the owner of the call pays a premium to the seller.
Buying a put option
As a buyer, you only have rights. It means that you decide what happens.
The only risk you take is the option premium that you pay to buy the option contract. You can never loose more than this paid premium.
It is your decision to exercise your right and actually sell the stock at the strike price, anytime before the expiration date (american style options only, this covers most stock and ETF. Indexes are usually european style)
When the stock trades above the strike price of the put, this is called out-of-the-money (OTM), it does not make sense to exercise your right. Why sell at the strike when you can sell at a higher price in the market?
When the stock trades below the strike price, this is called in-the-money (ITM), then it makes sense to sell at the strike. The strike is higher than the current market price. Or maybe you want to keep the stock for its dividend? In that case, you would sell the put option and make up the loss this way. The price of your put at expiration will be the difference between the strike and the market price.
Note that in-the-money and out-of-the money in the case of a put is the opposite than the case of a call.
And when the stock trades around the strike price, a little above or a little below, this is then called in both the case of a put and a call at-the-money (ATM)
An example:
When you buy a put option on stock ABC (the underlying) for a strike of 60€. Imagine that this trades for 0,5€. The option expires on May 19.
This means that you have the right to sell ABC at a price of 60€ between now and May 19. Keep in mind the premium you paid. So, you will be getting in the end 59,5 for the stock ABC. (and the trading costs/fees off course)
In the end you can compare this to an insurance. You pay a premium to insure the value of your items. When they are stolen or in an accident, your insurer pays you the insured value. When your stock would drop below the strike price, you get the strike price. No matter what the market wants to pay at that time.
Why buy a put option?
You own the stock ABC and want to protect the value of the stock. You think that the underlying will go down, then you can buy a put option. With a limited investment – the premium – you could get great protection. Imagine stock XYZ, worth now 60€. No matter what, you would like to secure the price at 55€. You buy an option that expires one month from now at a strike of 55€. You pay 1€ for this.
If at the end of the month the stock is worth 50€, then you secured the stock price at 55€. You thus prevented a loss of 5€
How?
you paid 1€ for the option
You exercise your right to sell the stock for 55€. As the market price now is 50€, you sell it with 5€ of profit compared to the market. You just multiplied your investment 5 times. Keep in mind the trading costs
Sounds easy?
Here is the caveat. The stock needs to be below 55€ before one month from now. If not, the options is worth 0€ to you. Imagine the stock is at 55,5€ one month from now and then drops to 50€ a week later. You lost your premium.
Why?
After the expiration date, you no longer have the right to sell the stock. You have now zero rights.
Selling a put option
When someone buys the contract, somebody else need sell the put option. The persons that sells is also called the writer of the put option.
In exchange for the premium, you now have the obligation to buy the underlying stock at the strike price. The premium is yours forever, the obligation will expire at the strike price.
Sounds lie, easy money, it comes with risk. What if the company goes banckrupt and you have a written put (you are short a put) with a strike of 35€. The stock is worth 0€ due to the bankruptcy. You still need to buy it at 35€. The maximum risk that you thus have is the strike price.
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