Invest Alpha

Put Options

What Are Put Options?

A put option is a financial contract that gives the holder the right, but not the obligation, to sell an underlying asset (like stocks, commodities, or indexes) at a predetermined price (called the strike price) within a specified time frame. The buyer of a put option anticipates that the price of the underlying asset will decrease. In contrast, the seller (or writer) of the put option hopes the price will stay the same or rise, allowing the contract to expire worthless.

The buyer of the put option pays a premium to the seller for this right. If the price of the underlying asset falls below the strike price, the buyer can sell the asset at the higher strike price, realizing a profit. If the asset’s price stays above the strike price, the put option expires worthless, and the buyer loses the premium paid.

Example of a Put Option

Suppose Company ABC’s stock is currently trading at $50 per share. You believe the stock price will drop in the next month and buy a put option with a strike price of $45, expiring in 30 days, for a premium of $2 per share. The contract covers 100 shares, so you pay $200 for the option ($2 × 100).

  • If the stock price drops to $40: You can exercise the option, selling the shares for $45 and buying them back in the market for $40. Your profit is:($45 – $40) × 100 shares – $200 premium = $300.
  • If the stock price stays at $50: The put option expires worthless, and your loss is the $200 premium paid.

Strategies Using Put Options

1. Buying Puts for Protection

A protective put is used by investors who own the underlying asset and want to protect against potential downside risk. By purchasing a put option, the investor limits their potential losses while still benefiting from any upside in the stock’s price. Example: You own 100 shares of XYZ stock, currently trading at $60 per share. To hedge against potential losses, you buy a put option with a strike price of $55 for $3 per share. If the stock drops to $50, you can sell at $55, limiting your losses.

2. Selling Puts for passive Income or to buy a stock at a discount

Selling put options can be a powerful strategy for generating income and acquiring stocks at a discount. This guide explores selling puts from both the seller’s and buyer’s perspectives.

Seller’s Perspective

Motivations

  1. Income Generation – Sellers collect premiums for writing put options, providing a steady source of income.
  2. Acquiring Stocks at a Discount – If the put option is exercised, the seller buys the stock at the strike price, often lower than the market price when accounting for the premium received.
  3. Leveraging Capital Efficiently – Selling puts allows investors to generate returns without immediately purchasing stock.

Strategies

  • Cash-Secured Puts – The seller holds enough cash to purchase the stock if assigned, ensuring a conservative and controlled approach.
  • Rolling Puts – If an option is nearing expiration and remains out-of-the-money, sellers can roll it forward to collect additional premiums.
  • Targeted Stock Acquisition – Selling puts on stocks the seller wants to own at a lower price can be a strategic way to enter positions.

Example

An investor sells a put option on XYZ stock with a $50 strike price, expiring in one month, for a $3 premium. If XYZ stays above $50, the option expires worthless, and the seller keeps the $3 premium. If XYZ falls below $50, the seller buys the stock at $50 but effectively at $47 when accounting for the premium.

Buyer’s Perspective

Motivations

  1. Hedging Against Declines – Buyers use puts to protect holdings from potential losses.
  2. Speculative Short Positions – A put buyer profits if the stock declines below the strike price.
  3. Leverage for High Returns – Buying puts allows investors to control a large position with a small investment.

Strategies

  • Protective Puts – Investors hold stock and buy puts to limit downside risk.
  • Speculative Puts – Traders buy puts outright when expecting a stock decline.
  • Spread Strategies – Buying and selling puts at different strike prices to limit risk and cost.

Example

A trader buys a put on ABC stock with a $100 strike price for a $5 premium. If ABC drops to $90, the put gains $10 in intrinsic value, netting a $5 profit after accounting for the premium.

3. Bear Put Spread

This strategy involves buying a put option at a higher strike price and simultaneously selling a put option at a lower strike price. The goal is to profit from a moderate decline in the stock price while reducing the cost of the trade.

Example: A stock is trading at $100. You buy a $95 strike put for $5 and sell a $90 strike put for $2. Your net cost is $3. If the stock drops to $90 or below, your profit is ($95 – $90) – $3 = $2 per share.

4. Straddle or Strangle using Puts

These strategies involve combining puts with calls to benefit from large price movements in either direction. Example: A stock is trading at $50. You buy a $50 strike put for $3 and a $50 strike call for $2 (straddle). If the stock moves significantly below $45 or above $55, the profits from one leg will offset the losses of the other, potentially leading to a net gain.