By Stock Options Channel Staff
The option to sell a specified quantity of a given stock at a given strike price, before a certain date.
Put options are a type of contract, giving the holder of the contract the right to sell the specified stock, at the specified price (called the "strike price"), with the contract expiring on the specified expiration date. These contracts are standardized and anyone with an options-enabled account at a brokerage can buy or sell them.
When might someone buy a put option? Suppose for example, a stock you follow was trading at $11/share and you were very bearish on that stock, thinking it will soon fall to $9 in a matter of months. With a brokerage account that allowed you to sell short, you could borrow someone else's 100 shares and sell them for $11. You would then "owe" 100 shares of that stock, which at the present price of $11 puts you on the hook for $1,100, the same amount of money you collected by selling the 100 shares. Then if the stock did fall to $9 as you predicted, you could "cover" your position by returning the 100 shares, buying the 100 shares back in the market for a cost of $9,000. In this scenario, you will have made a $200 profit.
Had the stock gone up to $13 and you decided you were wrong about your prediction and covered your short, you would have lost $200. Suppose that the $200 level is your threshold — the amount you are willing to lose betting against the stock. What if you risked your $200 buying put options instead?
A put option at the $10 strike price a few months out might trade in the neighborhood of 20 cents — a price that represents the "premium" per share from the strike price. The typical standard option contract represents 100 shares, meaning in this example each contract would cost you $20. So for $200, you could buy 10 contracts. Let's see what happens next in various scenarios.
In one possible scenario, you were wrong about the stock soon going to $9, and it continues to rise all the way to $13 and remains there all the way through to the expiration of your put options. In this scenario, you have lost all $200, your put options expired worthless. But notice that even if the stock jumped all the way to $20, your loss is capped at the $200 you spent buying the put options, because once they are already worthless, they cannot become even more worthless.
In another possible scenario, the stock trades lower but not all the way to $9, instead it trades down to your break-even point at $9.80. In this scenario, your contracts would be worth 20 cents at expiration, so you would be able to sell your contracts before expiration and recoup your $200 (we are ignoring commissions, but in reality you would lose money in the amount of your broker commissions).
And in the scenario where you were right and the stock plunged to $9, you would be up 60 cents per contract, with the contracts now worth 80 cents at expiration. They had cost you 20 cents, so you quadrupled your money, making $600 profit — three times the amount you would have made by selling 100 shares short at $11 and covering at $9. You have in essence leveraged your upside to being right about your bearish stance on the stock.
There are a lot more variables to buying put options that can be considered, for example instead of buying the $10 strike in the above example, which was "out of the money" (meaning, the stock would have to fall to reach that strike price), what if you had bought the $15 strike? With different strike prices, it is possible to shift the risk/reward spectrum.
While buying puts can be a way to bet against a stock you dislike, another strategy to consider is being on the other side of the trade and selling puts for income against stocks you like and would want to buy.
Now Learn About: Call Options »
Since 2003, our company has operated the stock picking discussion community ValueForumTM, where members gather each year for an event we call InvestFestTM. Both online and at these events, stock options are consistently a topic of interest. The two most consistently discussed strategies are: (1) Selling covered calls for extra income, and (2) Selling puts for extra income.
The Stock Options Channel website, and our proprietary YieldBoost formula, was designed with these two strategies in mind. Each week we put out a free newsletter sharing the results of our YieldBoost rankings, and throughout each day we share even more detailed reports to subscribers to our premium service.
On the CALLS side of the options chain, the YieldBoost formula looks for the highest premiums a call seller can receive (expressed in terms of the extra yield against the current share price — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being called away.
On the PUTS side of the options chain, the YieldBoost formula considers that the option seller makes a commitment to put up a certain amount of cash to buy the stock at a given strike, and looks for the highest premiums a put seller can receive (expressed in terms of the extra yield against the cash commitment — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being put to the option seller.
The results of these rankings are meant to express the top most ''interesting'' options identified by the formula, which are meant as a research tool for users to generate ideas that merit further research.
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