Put Options: How to Use Them in Your Trading Strategy
Put options can play a significant role in the investment goals of some traders. They can offer a range of strategies and potential benefits for different market conditions. Here’s our guide to what they are, how they may be utilized, and their potential pros and cons.
What are put options
A put option is a contract that gives the buyer the right, but not the obligation, to sell a specific amount of an asset at a predetermined price (strike price) within a set time frame (expiration date). These options are a type of derivative instrument that can be traded on a variety of assets, including stocks, currencies, bonds, and indexes. Option investors often purchase put options when they expect the price of an asset to fall, enabling them to possibly sell the asset at a higher price, to potentially profit from the drop in the market price.
How put options work
As mentioned, investors typically buy put options when they anticipate a decrease in the underlying asset's value but for sellers of put options; they are obligated to buy the asset at the strike price if the buyer chooses to exercise the option. The premium paid for the put option represents its cost is influenced by factors such as the asset's current price, the strike price, time until expiration, and market volatility. Understanding how put options operate can allow investors to hedge against potential losses, speculate on price declines, or engage in more complex trading strategies to manage portfolio risk more effectively.
Major elements of a put option
Strike price: The predetermined price at which the buyer of the put option can sell the underlying security. In a put option contract, the strike price is the predetermined price at which the holder can sell the asset to the option writer (seller) if they choose to exercise the option before or at its expiration date.
Premium: The price a buyer pays to purchase an options contract. This premium represents the cost of acquiring the right to buy or sell an underlying asset at a specified price (the strike price) before the contract expires. It’s determined by several factors, including the asset’s current market price, the option’s strike price, time value(or the extrinsic value). If the option is out of the money (OTM), its value is solely extrinsic.
Expiration: As a put option gets closer to expiration, its time 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.
Long put vs. Short put
For a long put, an investor has a bearish outlook with limited risk (the premium paid) and a significant profit potential limited to the underlying stock going to zero, if the underlying asset drops significantly. For a short put the opposite is true: when an investor sells a put, they have a neutral/bullish outlook, with higher risk (potentially large losses) and limited profit (premium received).
Here's a look the potential theoretical maximum profit, theoretical maximum loss and the breakeven point for a long put vs a short put.
Long put
Theoretical maximum profit: The profit from a long put option is potentially substantial if the underlying asset's price falls significantly below the strike price, theoretically down to zero. The calculation: Strike price−underlying asset price−premium paid x number of contracts x option multiplier (100 shares)
Theoretical maximum loss: Limited to the premium paid for the option. If the underlying asset's price remains above the strike price, the put option may expire worthless, and the loss would be the premium paid. The calculation: Premium paid
Breakeven point: The total cost of the option is recovered by the difference between the strike price and the underlying asset price. At the breakeven price, the profit from exercising the put option exactly offsets the premium paid for the option. So, if the underlying asset price is at or above the strike price at expiration, the put option expires worthless, and you lose the premium. If the price falls below the breakeven point, you can potentially make a profit. The calculation: Strike price−Premium paid
Short put
Theoretical maximum profit: Limited to the premium received from selling the put option. This occurs when the underlying asset’s price is at or above the strike price at expiration and the option expires worthless. The calculation: Premium received
Theoretical maxium loss: Theoretically significant if the underlying asset’s price falls substantially, which can include the underlying stock falling to zero. There's also the risk of early assignment The calculation: Strike price−underlying asset price−premium received x number of contracts x option multiplier (the normal option multiple is 100 shares per option contract).
Breakeven point: Total premium received offsets the potential loss from having to buy the asset at the strike price. The calculation: Strike price−premium received
Buying a put option
Buying a put option grants you the right, but not the obligation, to sell a stock at a specified strike price before the option expires. Put buyers typically aim for the stock’s price to drop below the strike price, making the option “in the money.” Ideally, the stock’s price falls past the “break-even point” where the option becomes profitable after accounting for the cost of the premium paid.
For example, if you buy a put option on a stock with a strike price of $50, and the stock falls to $40, by expiration you can exercise the contract to sell the underlying shares at $50 assuming a short position.
To potentially realize a profit, you would then buy to close the short shares at the market price. If the stock price doesn’t drop below $50, the put expires worthless, and you lose the premium paid.
Selling a put option
Let's say you're neutral on a stock and you decide to sell put options on it to potentially generate some additional income. The stock is currently trading at $100 per share and you believe it won't significantly change in the near future. You sell a put option with a $95 strike price; the expiration date is in two months and you receive a $3 premium per share.
By selling this put option, you are obligating yourself to purchase the stock at the $95 strike price if the option is exercised. If the market price of the stock falls to $90, the put option buyer may choose to exercise their right, and you would need to buy the shares at $95 each. This scenario results in a potential loss offset partially by the premium collected; however, if the stock is at or above $95 at the expiration date, the put option expires worthless, and you retain the full premium as profit.
Factors that affect put options price
Several factors can influence the pricing and behavior of put options, impacting both potential buyers and sellers. Here's a few to consider:
The more the current underlying asset price exceeds the strike price, the less valuable the put option becomes because it's less likely to be exercised profitably.
Typically, the longer the time remaining, the higher the option's premium due to the increased potential for price movement favoring the option holder.
Higher volatility can often lead to a higher premium as increased price swings can raise the probability of the asset's price falling below the strike price.
Interest rates can indirectly affect option pricing by influencing the costs of carrying the position or the alternative yields an investor could achieve.
Anticipated dividend payouts of the underlying stock may alter investors' perceptions of the stock's potential value change.
How to Buy and Sell Put Options on Moomoo
Moomoo provides a user-friendly platform for trading options. Here's a step-by-step guide to get you started:
Step 1: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Navigate to Options> Chain located at the top of the page.
Step 3: By default, all options with a specific expiration date are shown. For selective viewing of calls or puts, simply tap "Call/Put."
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 4: Adjust the expiration date by choosing your preferred date from the menu.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 5: Easily distinguish between options: white denotes out-of-the-money, and blue indicates in-the-money. Swipe horizontally to access additional option details.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 6: Explore various trading strategies at the screen's bottom, offering flexibility for your investment approach.
Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Put option strategies and examples
Investors who trade put options, whether buying put options or selling put options, should consider diffrent variables involved in securing the option they’re looking to trade. With the many different choices involved, specificity is key to building a put option investment strategy. Investors need to define:
The underlying security in the options contract
A bearish, neutral or bullish option strategy
The expiration date
The strike price
The premium
The order type (e.g., a market order vs. limit order)
Here's a look at some different put strategies investors may pursue.
Protective Puts
A protective put is an options strategy used by investors to potentially hedge an existing long position in a stock (or other asset) by buying a put option on that same asset. The goal is to help protect against downside risk while still allowing for potential upside gains.
The investor buys a put option on the stock and if the underlying stock price declines, the put option may increase in value, which could offset the losses from the stock; if the stock price rises, the investor can potentially benefit from the stock’s appreciation while only losing the premium paid for the put option.
Put spreads
A put spread is an options trading strategy that involves buying and selling put options with different strike prices but with the same expiration date. This strategy can limit both potential gains and losses.
A trader may use a bear put spread (debit put spread) when they anticipate a moderate decline in the underlying asset’s price, but not a significant drop or they may use a bull put spread (put credit spread) when a trader expects the underlying asset to remain stable or increase moderately.
Naked puts
A naked put (also known as an uncovered put) is an options trading strategy where an investor sells a put option without holding a short position in the underlying asset or having sufficient cash to cover the potential obligation to buy the asset. This strategy is typically used when an investor is bullish or neutral on the underlying asset and believes that the price will remain above the strike price of the put option. However, this strategy also comes with substantial risk, as the stock price can continue to fall, potentially requiring the seller to purchase the underlying stock at the the predetermined strike price, which would be higher than its market value.
Covered puts
A covered put is an options trading strategy where a trader sells a put option on an asset they already hold a short position in (meaning they’ve already sold shares of the asset and plan to repurchase them later). This strategy is designed to generate income through the premium received from selling the put option, while leveraging the short position the trader has already taken on the underlying asset. With the put, it caps potential gains but the short seller of the shares is still exposed to unlimited losses. Therefore, it is still a very risky strategy.
Potential pros and cons of put options
Potential pros
Hedging: Can be used to help protect against some downside risk in an investment portfolio.
Lower capital: Generally has a lower initial capital requirement as trading an equivalent amount of the underlying asset.
Limited risk: For a buyer of a put option, the theoretical maximum loss is limited to the premium paid for the option. The potential gain can be signficant if the asset's price declines sharply.
Potential cons
Risk: There's a chance of losing the entire principal invested.
Time decay: Can lose value over time as the expiration date approaches.
Complexity: Can require the investor to accurately forecast the underlying asset's relative movement and direction as well as the timing of these dynamics.
Long Put Options vs. Long Call Options
The main difference between a put option and a call option is that before expiration, a put option gives the buyer the right to sell an asset at a specified price (strike price), while a call option gives the buyer the right to buy an asset. Additional differences include traders buy put options when they think the price of the asset will decrease, but they can buy call options when they think the price of the asset will increase.
Put options vs short selling
Put options and short selling are both strategies that can be used to potentially profit from a decline in stock prices, but they differ in several ways:
Short selling involves borrowing shares and selling them, then buying them back at a lower price. Put options give the holder the right to sell a stock at a predetermined price within a set time frame.
Short selling has unlimited risk, while long put options limit losses to the premium paid.
Short selling can be more relatively expensive than put options because of costs like borrowing charges and margin interest.
Put options can be used to hedge a long position or to speculate when an investor is bearish about a stock.
When deciding between short selling and put options, investors should consider their risk tolerance, investment goals, and market conditions.
When short selling there is no limit on how high a stock price could rise so the potential loss is unlimited. Other risks include dividend risk and margin risk, this strategy is not appropriate for all investors.
FAQs about put options
How are put options exercised early?
A put option is exercised when the holder exercises their right to sell the associated underlying shares at a predetermined price (strike price) before the option expires. The put option holder may profit if the stock price falls below the strike price before the expiration date.
A put option can be exercised at any time up to the expiration date for American-style options, but only on the expiration date for European-style options. To exercise an option before expiration, the investor must notify the broker of their decision. For options that expire in-the-money, they will usually be exercised automatically by the broker.
Moomoo will automatically liquidate the options upon expiration only in cases where the account meets margin requirements, and it is important to verify that this applies to your account. Liquidation is not guaranteed, and investors should monitor their positions closely.
When to consider buying or selling a put option?
An investor may want to buy put options if they have a bearish market sentiment and they hope to hedge against losses or as a way to potentially profit from a downturn. When an investor believes implied volatility may rise, it could be another time to consider buying put options or prior to a significant event that may negatively impact a stock.
An investor may consider selling put options if they believe stock price will stay the same or increase; this potentially can generate income from the premium received. Selling puts when implied volatility is high or if an investor is willing to buy the underlying stock at a lower price, then selling puts can be an effective way to acquire shares at a discount while also possibly earning premium income.
Are there any alternatives to put options?
Short selling can be an alternative to long put options, but it's riskier because the stock's value can increase indefinitely, meaning the potential loss is theoretically unlimited. However, the potential reward is limited because the stock price can't fall below zero.