How put options work

Buying put options

Remember – buying a put option means you believe the value of an underlying asset will fall in value during the time of the contract. So, buying a put option can also be seen as a protective, risk-averse move to hedge against the prospect of the asset’s value declining. 

Let’s say that you currently have a long (buy) position on the underlying asset. Buying a put option can be used as a form of insurance for your long position if the asset’s value falls against you. However, if the price of the underlying asset continues to rise in your favour, all that you’ve lost is the premium charge to take out the OTM put option in the first place. This should be comfortably balanced by your gains on the underlying asset. 

Is buying a put option the same as short selling? 

Buying a put option and short selling an underlying asset are two bearish approaches to the financial markets. However, there are some key differences between them too. For instance, a buyer of put options has a capped loss from the moment they enter into the contract. 

Their maximum loss is limited to the premium charge paid to the broker. You’ll be pleased to know that brokers do not require you to have a margin account to buy puts, so it’s easy to adopt a strict bankroll management strategy with puts. 

On the flip side, short selling carries more inherent risk. Theoretically, the risk to a short seller is unlimited, because when someone short sells an asset there is no guarantee the price will fall. The price could continue to rise for years to come, leaving short sellers in a deep, red hole. That’s before you take into consideration additional charges such as margin interest and stock borrowing fees. 

For newcomers to investing, declining assets, buying puts represents a safer starting point than short selling. One way to mitigate the dangers of short selling is to develop a watertight risk management strategy with a strict risk-reward ratio and stop loss orders. 

Selling put options 

If you believe the price of an underlying asset is likely to rise in the coming months, you could look to become a put seller. By selling a put option contract, you are confident that the market value of an asset will be steady or strong in the short-to-medium term. 

As a put seller, you receive a pre-agreed premium per share to enable the buyer to purchase the options contract. However, there is much more financial downside to being a put seller. Unlike a put buyer, sellers must buy the underlying asset if it reaches the strike price. Subsequently, put sellers are required to have sufficient funds in their account or pre-agreed margin capacity with their broker to purchase the asset from the put buyer. 

A put option will not often be exercised until the underlying asset’s value falls beneath the strike price. As soon as a put option is in the money, sellers have put the stock and are required to buy it at the strike price. So long as the underlying asset’s value stays above the strike price, the put seller stays in profit thanks to the premium charge of the written put. 

There is nothing stopping put sellers to write multiple puts on the same underlying asset if they are confident in the security's stability price and are looking to earn additional premium charges. 

Why put options remain a popular investing tool 

There are several reasons for using a put option – aside from hedging against the potential for an equity’s value to plummet. 

Risk averse investors enjoy using put options to limit their exposure. For instance, an investor seeking to profit from the falling value of an equity could purchase a single put option and limit their overall downside. At the opposite end of the spectrum, those who short-sell the same equity have no definitive downside if the asset’s value was to rise rather than fall. 

In addition, put options investors can sell on their existing options to generate additional revenue if they wish. It can be a good move in a bull market, where assets are less likely to be put to the seller. 

Prospective investors in a stock that’s currently too rich for their bank may use a put option to achieve a more realistic entry point. They may sell a put option on said asset and if it falls below the put’s strike price, they can purchase the stock at the lower price and take a minor hit on the put option, which is a small price to pay for discounted entry into the asset. 

Put options in summary 

• Put options give buyers the right – not the obligation – to sell an underlying asset if it hits the specified strike price. 
• Put options give sellers the obligation – not the right – to buy an underlying asset if it hits the specified strike price. 
• The price of put options varies based on the value of the underlying asset, the strike price of the put and the time to expiry of the contract. 
• It’s possible to buy and sell put options across a broad spectrum of securities, including equities, indices, commodities, and forex. 
• Buyers lose value in put options when the underlying asset increases in price. 
• Sellers lose value in put options when the underlying asset falls in price.