Put Options

Put Options

In the world of options investing, there are many different terms used from the very simple to the very complicated.

There are also numerous options trading strategies available to investors, and these also range from simple to quite complex.

For an investor to be able to properly utilize options strategies, one must have a solid understanding of what options contracts are and how they work.

For starters, one must thoroughly know the mechanics of the two different types of options, known as calls and puts.

In this presentation we will discuss put options and their uses.

What Exactly Is a Put Option?

A put option gives the buyer the right but not the obligation to sell or be short the underlying instrument at a certain price by a certain date in the future.

It is important to note that an option is exactly what its name implies and that investors have the right to sell or be short but are not required to do so.

What Are Put Options Used For?

Puts have numerous uses one of which is to try to protect a long stock position from a drop in the price of the shares.

Let's suppose that investor Bob owns 100 shares of ABC which is currently trading at $40 per share.

Bob is worried that the stock is currently over extended in price and wants to protect his position should the stock price drop.

One way Bob can do this is by purchasing a put.

If Bob purchases the front month $38 put option, Bob will have the right but not the obligation to sell the shares at $38 per share regardless of how low the stock price falls.

Bob would have this right until the option expires.

Puts Have Different Strike Prices

Put options are listed at different strike or striking prices.

These strike prices are the price at which one may exercise the option.

Very active, heavily traded stocks may have many different available strike prices while stocks with low volume and low volatility may only have a few strike prices listed.

In the previous example, Bob's put option had a strike price of $38 per share.

Puts Are a Wasting Asset

All listed options come with an expiration date.

On this date, options are either abandoned and expire worthless or may be exercised if they are in-the-money.

Because options have expiration dates, the clock is the option's enemy.

Every day that goes by, an option is losing value in the form of theta, or time decay, all else remaining equal.

This time decay is exponential and becomes quite significant as an option approaches its expiration date.

Puts are listed for many different expiration dates at any given time.

One may be able to purchase puts with years until expiration or just days.

Put options are listed for regular monthly expiration cycles which expire on the third Friday of each month.

Puts are also available for end-of-month expiration cycles and even weekly expiration cycles as well.

By having so many different expiration cycles to choose from, investors may tailor fit their put hedges on long stock positions or craft various types of positions using put options.

Regardless of the strategy being used, investors must account for the time decay of long put options.

This time decay can cause losses even when the anticipated market movement occurs.

What Affects Put Option Premiums?

The price at which a put option trades is known as the premium.

Premiums can vary according to the stock they are listed on and many other factors.

One of the biggest factors that may affect put option premiums is that of vega, or the option's sensitivity to changes in implied volatility.

Option premiums are largely determined by the perceived risk of the position, and therefore puts on volatile stocks may be considerably more expensive than puts on non-volatile stocks.

In addition, premiums will also be determined by time until expiration, strike price, and many other factors.

Exercising a Put Option

When a put option is bought to hedge a long stock position, the put will either expire worthless, be exercised, or be sold at a gain or loss at any time prior to expiration.

Let's discuss what occurs when a put is exercised.

Let's say that investor Bill owns 200 shares of XYZ at a price of $40 per share.

Shares of the stock are currently trading at $39 per share and although Bill likes the long term prospects of the stock, he wants to protect himself from any large potential losses.

Bill decides to buy puts at the $38 strike price that expire in three months.

Now let's further suppose that over the next few weeks the stock price continues to trend lower and the selling in it accelerates.

The shares are now trading at $35.00 per share and Bill decides that his outlook on the shares has gone from bullish to bearish.

Bill therefore elects to exercise his long $38 put options.

When Bill exercises these puts, he is assigned a short position in the shares from the strike price of $38.

Because Bill is already long the shares from $40, the short position at $38 automatically offsets his long position making his position flat.

When calculating his loss, Bill will subtract the strike price of his long puts ($38) from the price he bought the shares at ($40) and then add the premium paid for the puts.

If Bill had paid $.75 for the long $38 puts, then his net loss would be calculated as $40-$38 equals $2.00 loss on shares plus $.75 premium paid for each option.

Since Bill had 200 shares, he bought two options.

The net loss is then calculated to be $40-$38 per share equals $2.00 loss per share X 200 shares equals $400 loss on shares plus $1.50 total premium paid for two put options for total loss amount of $550.

If Bill did not have the long puts and had to sell his shares at the current price of $35, he would be facing a loss of $5.00 per share or $1000.

Considerations When Buying Put Options

When one is looking to buy put options, it is important that he or she determine the reason for buying puts.

There can be great differences in how one goes about buying puts based on what one is trying to accomplish.

A hedge position may be initiated very differently from a speculative directional based position.

As discussed, one must account for the effects of time decay and buy options with enough time on them to give their market thesis time to play out.

One should also always consider implied volatility levels when buying puts.

It can be very easy for investors to overpay for put option protection in volatile markets.

Volatility is something that one should be familiar with to try to avoid buying overpriced, expensive options that may create losses just based on a drop in implied volatility.

Protection and Opportunity

Put options are extremely useful and can provide excellent protection for long positions when used properly.

In addition, puts may be used to try to profit from a bearish bias in a stock or market or to try to capitalize on an increase in implied volatility levels.

Before buying put options, one must acclimate themselves with all of the nuances of long option positions first.

When used by knowledgeable investors, long put options may give an investor peace of mind and opportunity for potential profit.