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The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. Put options are most commonly used in the stock market to protect against a fall in the price of a stock below a specified price. If the price of the stock declines below the strike price, the holder of the put has the right, but not the obligation, to sell the asset at the strike price, while the seller of the put has the obligation to purchase the asset at the strike price if the owner uses the right to do so the holder is said to exercise the option.
In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless.
If the strike is K , and at time t the value of the underlying is S t , then in an American option the buyer can exercise the put for a payout of K -S t any time until the option's maturity date T. The put yields a positive return only if the underlying price falls below the strike when the option is exercised. A European option can only be exercised at time T rather than at any time until T , and a Bermudan option can be exercised only on specific dates listed in the terms of the contract.
If the option is not exercised by maturity, it expires worthless. The buyer will not usually exercise the option at an allowable date if the price of the underlying is greater than K. The most obvious use of a put option is as a type of insurance.
In the protective put strategy, the investor buys enough puts to cover their holdings of the underlying so that if the price of the underlying falls sharply, they can still sell it at the strike price. Another use is for speculation : an investor can take a short position in the underlying stock without trading in it directly. Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful for hedging.
Holding a European put option is equivalent to holding the corresponding call option and selling an appropriate forward contract. This equivalence is called "put-call parity". The terms for exercising the option's right to sell it differ depending on option style.
A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration. The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.
That's known as a protective index put. When you sell a put option, you agree to buy a stock at an agreed-upon price. It's also known as shorting a put. Put sellers lose money if the stock price falls. That's because they must buy the stock at the strike price but can only sell it at a lower price. They make money if the stock price rises. That's because the buyer won't exercise the option. The put sellers pocket the fee.
Put sellers stay in business by writing lots of puts on stocks they think will rise in value. They hope the fees they collect will offset the occasional loss they incur when stock prices fall. Their mindset is similar to an apartment owner.
He hopes that he'll get enough rent from the responsible tenants to offset the cost of the deadbeats and those who wreck his apartment. A put seller can get out of the agreement anytime by buying the same option from someone else. If the fee for the new option is lower than what he received for the old one, he pockets the difference.
He would only do this if he thought the trade was going against him. Some traders sell puts on stocks they'd like to own because they think they are currently undervalued. They are happy to buy the stock at the current price because they believe it will rise again in the future. Since the buyer of the put pays them the fee, they actually buy the stock at a discount.
Selling (also called writing) a put option allows an investor to potentially own the underlying security at a future date and at a much more. Short selling and put options are used to speculate on a potential decline in a security or index or hedge downside risk in a portfolio or stock.
Cash Secured Put Sale: You keep enough money in your account to buy the stock or cover the put. Naked Put: You don't keep enough in the account to buy the stock. Put options are used for commodities as well as stocks. If the stock price rises, you get a nice gain on the stock, but your put option will expire and become worthless, so you'll lose the amount of the premium you paid for it. If the stock price plummets, you can exercise your put option and sell your stock for the strike price, limiting your loss on the stock to a predetermined level.
You can generate a steady stream of income by selling, also known as writing, cash-secured put options. This strategy involves selling put options with a strike price that is at or below the stock's current market price. You'll receive a premium for agreeing to buy the stock for the strike price if the put option is exercised. If the stock's market price increases, the option will expire, you get to keep the premium and you can sell another put option and collect another premium. If the stock price declines and the option is exercised, you have enough cash set aside in your brokerage account to cover the purchase price, which will be offset somewhat by the premium you received for selling the put.
A bear put spread is a conservative option strategy that involves buying a put option while at the same time writing another put option on the same stock with the same expiration date but with a lower strike price. If the stock price declines below the long put strike price, the options value increases and you make a profit. You also have a profit from the premium you received from selling the put.
To see current option prices, you just look up an option table, such as on Google Finance or Yahoo Finance or through your online broker. Right now, this Selling Puts strategy is crushing the market. So your potential losses could be substantial, even unlimited. It truly depends on where the stock is trading at the time we sell the puts and how much premium we wish to bring in. Keep reading to learn more about selling options for income.
The trade-off happens if the stock price continues to decline below the strike price for your short put, in which case the option could be exercised, requiring you to buy the stock. Mike Parker is a full-time writer, publisher and independent businessman. He helped launch DiscoverCard as one of the company's first merchant sales reps.