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The Put Option: What are they, and how are they used.

What is a Put:

A put is a contract between two people. For each contract, the person who bought the put has a right to sell one hundred shares to the person that sold the put. The person who sold the put is obligated to buy the shares. The price at which the exchange takes place is called the strike or exercise price. The person buying the put typically pays a premium to the seller, called extrinsic value, over the inherent value of the put. Example: If the stock is at $45 and the put has a strike price of $50, it has an inherent value, called the intrinsic value, of $5 since the stock can be purchased for $45 and sold for $50. The put would cost more than $5. How much more depends on the equity’s expected price movement for the life of the option, which is called Implied Volatility. It is a little more complicated than that, but not much more.

When a put is purchased it is called a long put. When one is sold it is called a short put. When a put has intrinsic value, it is called in-the-money. When the put has only extrinsic value, it is out-of-the-money. That means the strike of the put is below the price of the equity.

How are they used:

Before we get into how they are used there is an important property of options to know. The extrinsic value of an option is also referred to as the time value. The longer the time period you purchase, the more the put will cost for the same strike. The extrinsic value/time value will decay with time. Time decay is not linear. The closer the put is to expiration, the faster the extrinsic value decays.

Many strikes are available for puts and many time periods. How many of each depends on the equity. The more of an equity’s options that people trade, the more strikes and time periods will be made available. The more strikes and time periods that are available, the more ways that the put option can be used.

Some use the put option to “protect” a stock position. They buy a put contract so if the equity drops, they can still sell the stock for the strike of the put. Of course the put was purchased at a cost and when a put is exercised that cost is forfeited. Long puts are used to protect a stock position for earnings. Long puts can be used to protect a stock position for “Sell in May and go away”. Instead of selling your stock make money with a long put.

A great way to use long puts is to make money. You do not have to have a stock position to buy a put. If you believe that a stock’s price is going to drop, you could buy a put and when the put goes up in value, the stock price drops, you can sell the put for more than you paid for it. Don’t get greedy though, take profits often. Remember time is working against you in a long put.

Since time is working against a long put, it is working for a short put. We certainly know the phrase buy low and sell high, how about sell high and buy low? That is one way short puts are used. If you believe a stock will stay where it is or go up, you can sell a put and either let it expire OTM or buy it back at a lower price, as long as you are right. Remember that the short put carries an obligation so the broker may reserve enough cash in your account to cover that obligation. If the stock drops unexpectedly, you will wish you had a long put. But that is another trade for another article.

Those are the basics of the put option. An analogy I like to use with options trading is swimming. Read a book on swimming and dive into the deep part of a lake and you’ll drown. Read this article on puts and start trading, you will lose your money. Read a book on swimming, get a coach and practice in a nice pool and you’ll learn to swim. So if you have an interest in making money in any direction with limited risk, get an education on options trading and practice in a virtual account. Practice hard and you can make lots of money.

Ken Bailey
OptionsANIMAL Instructor

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