Put Option Basics
Research for Online Investors

by John Dalt

1/25/10

What does it mean to buy a “Put”? A “Put” is an option contract that gives you the right to sell the underlying stock at a predetermined price on a certain date. The writer (seller) of the ‘put’ is obligated to purchase the underlying stock at the strike price. Put contracts are the opposite of ‘Call’ contracts. Call contracts are bought when you think the price of a stock will increase. When you own a ‘call’ contract, you have the right to buy a stock at a set price for a predetermined amount of time. The key to these two instruments is you are in control. You can exercise the contract, or let it expire.

You have the right to buy the underlying stock with a ‘call’ (normally exercised only if the stock moves above the strike price). You have the right to sell the underlying stock with a ‘put’ at the strike price (normally exercised only if the stock falls below the strike price).

Put contracts can be used to ‘protect’ a position, or as a tool to capitalize on a stock going down in price. This is akin to shorting a stock, but buying a ‘put’ limits your risk to the premium paid for the ‘put’ option. Think of a ‘Put’ as your option to put a stock to the seller.

Let’s say ABC company stock is trading at a high price and the investor wants to protect against a possible fall in the price. In this case we don’t want to sell the stock, but buy protection against a drop in the stock price. Put options are like call options; each option contract is for 100 shares of the underlying stock but is priced at cost per share. A put price at $1.00, means $1 dollar per share and will cost $100.00 (plus commission) when executed.

Let’s look at an example:
present stock prices and amount committed:

ABC stock priced at:    $50 x 100 shares        =     $5,000.00

March $49.00 put bought @ $1 x 100 shares =  $   100.00

Total value of stock and cost of put:                      $5,100.00

Third Friday in March price:

ABC stock priced at:     $45.00 x 100 shares =     $4,500.00

March $49.00 put sold @ $ 4.00 x 100 shares = $   400.00

ABC stock and put value at end of period:      =     $4,900.00

Loss:                                                                        $   200.00

In this instance our investor paid $1.00 per share to protect his shares in ABC. Rather than suffering a $5.00 loss per share, the put increased in price as the share price dropped. The investor can sell his shares to the seller of the put, or just ‘sell to close’ the put before close of business on the option expiration day. The investor experienced a total loss of $200 rather than $500 by owning a put on his shares.

If the investor was wrong, and ABC Company’s stock increased in price, the put option would expire worthless. In this case, the investor looks at the ‘put’ as insurance. Just like your homeowners insurance, we pay for it just in case we need it!

You can also buy ‘put’ contracts to capitalize on a stock price going down, without owning the underlying stock, rather than shorting the stock.

Let’s look at the same example:
present stock prices and amount committed:

ABC stock sold short at: $50 x 100 shares        =    $5,000.00

March $49.00 put bought @ $1 x 100 shares   =    $   100.00

Third Friday in March price:

ABC stock buy to cover at: $45.00 x 100 shares =$4,500.00

March $49.00 put sold @    $ 4.00 x 100 shares = $   400.00

Gain on ABC short                                                  = $   500.00

Gain on $49 put:      $400.00 - $100.00                = $   300.00

You made a 10% gain on risk capital in the short transaction, this is more than on the ‘put’ contract, but your potential losses were unlimited, because the price of ABC stock could have gone higher, much much higher.

The ‘put’ contract cost $100 and returned $400 for a $300 gain, a 300% return on risk capital. You had no potential losses other than the original $100 purchase price of the ‘put.’

What is the largest disadvantage to ‘put’ contracts; time.  You own a contract to sell that is limited by time, and time decay can eat into your profits quickly.  In the example above, our investor paid $1 to have the right to sell the stock at $49.  If ABC ended the time period at $48.50, you would make back $0.50 for a loss of $0.50 per share.  It doesn’t matter if the stock goes to $45 per share a week after the option expires.  You can be right in your prediction, but wrong in time frame and lose money.  If you shorted the stock, you could buy to cover for the $48.50 per share and make a smaller profit or chose to wait longer for the lower target price.

Puts and calls may not be bought, or sold, in IRA or 401K accounts.  The exception being covered calls, such as in our Buy, Sell, Hold Service.  You must sign an option addendum with your online brokerage company to sell and buy options.

To buy a put option we enter the stock symbol, the month and the strike price.  Each online broker has a help screen to assist you entering your order.  Enter the quantity of contracts you want to purchase, remember each contract is for 100 shares.  Option contracts trade with a Bid and Ask price, we highly recommend using limit orders on option contracts as the ‘spread’ is usually wider on options than on stocks.  We use the ‘Buy to Open’ to place the order.  This refers to ‘Opening’ the contract.  If we chose to sell the option contract before it expires, we would ‘Sell to Close’ to close the contract.

We have talked about buying put option contracts; you can also sell put options.  Using the ABC company trading at $50, if we believed it would increase in price through the option expiration date, we could sell to open the $49 put for $1.00 per share.  If it stays above $49 through option expiration day we get to keep the $1.00 premium.  If ABC falls under $49 per share we would have to buy the stock at the $49   Then we are faced with the decision of holding the stock or selling it for less than the strike price.  This is not a trade you want to enter lightly, it can be dangerous. Thus it is called selling a “naked” put.

Selling puts can be used to acquire stocks at a price lower than today's market price.  If you do your research and decide you want to own ABC company for a long-term investment, why not sell (write) puts on it to buy at a cheaper price.  You will be paid to wait in option premium, which further reduces your cost in ABC if the stock is "put to the seller".

I hope this has been helpful to you.  If you have experience in options, it may seem elementary, but remember the first option you bought.  We all have to start somewhere.  I encourage you to start by buying one contract, and monitoring your trade for experience.  Experience is the very best teacher, and will help you understand the concepts better.

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