Aja McClanahan is a personal finance writer who has a story of getting out of over $120,000 in debt. She's been featured in Yahoo! Finance, MarketWatch, U.S. News and World Report, Kiplinger and has written for publications like Business Insider, Credit Karma, Inc., and many others. Aja writes about investing and personal finance for Wealthsimple. In her spare time, she manages her own investment portfolios for herself, husband, and two kids. Aja double majored in Spanish and Economics and holds a Bachelor of Arts degree from University of Illinois at Urbana-Champaign.
If you’re new to investing, learning about put options probably isn’t the first thing on your list of topics to cover. After all, the term itself is associated with a bevy of terms that tend to frighten newbie investors: covered calls, naked calls, short puts, strike price, etc. It can all seem so complex.
The average investor might assume options are for the likes of seasoned investors. But before you “put” the idea of learning more about put options aside, consider acquiring a basic understanding of this investing concept.
Note: As a trader, option markets can be extremely volatile and fraught with risk. Put options could prevent you from losing long-term gains in a down market and could be way to improve your portfolio performance. But there’s no guarantee of returns.
Here’s a short guide to put options to get you started.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
What is a put option?
An option is a contract that spells out the terms of a future transaction within a specific period of time and for a specific price for an underlying asset—typically a security like a stock or ETF.
Essentially, it gives an investor the right, but not the obligation, to buy or sell an underlying security according to the terms spelled out in the contract. Because options don’t convey ownership of an asset, they are known as a derivative investment, meaning the price of the option is linked to the price of something else.
Buying a put option is the right to sell shares of a security at certain “strike price” within a certain time frame, the expiration date. The put option’s price is known as the premium and is quoted in dollars per share for a quantity of 100 shares.
Buying a put option is akin to shorting a stock, or “betting” that the stock’s price will decline. The main difference between shorting a stock and buying a put is that the put has an expiration date.
If the stock price drops below the strike price before the expiration date, you, as buyer of the put and owner of the underlying stock, can exercise your right to sell the stock, above the market price. If you don’t own the stock, the alternative is to sell the put option before the expiration date and earn profits on the premium collected the sale of the put option.
In another scenario, you can sell a put option. When you sell, or write a put option, you are obligated to buy a security at the strike price from a buyer should they exercise the option to sell the stock by the expiration date. Your break-even point occurs at the strike price minus the premium you charge for the transaction.
In this case, you are assuming a stock price will fall to the strike price you’ve written into your options contract. This is known as a “short put.” You stand to make a profit from the premium you charge for the put option as long as the price of the stock stays above the strike price.
Should the stock price fall below the strike price in your contract, you are on the hook for purchasing 100 shares of the stock at that strike price. You lose more money as the stock price declines below the strike price.
How does a put option work?
Another way to think about buying put options is in the context of how insurance policies protect an asset, like a car, for a premium. Imagine you’ve got a vehicle worth $20,000 and you purchase vehicle insurance that will cover repairs or replacement in the event that your vehicle is wrecked or stolen. Let’s say the annual premium to insure the car costs $900, which you’ll pay at once to start the policy.
Although this car costs $20,000, your initial downpayment and three months of payments cost about $4,100 altogether. With the insurance premium of $900, your total investment in the vehicle so far is $5,000.
In this situation, there are few outcomes that can determine the gains, if any, you stand to make with your vehicle and the insurance policy. Let’s choose the outcome that most clearly demonstrates how buying put options work.
Let’s say that your car is in an accident and the insurance company decides to totals out the vehicle. They pay you for what the car is now worth: $18,000. (Cars depreciate quickly after they are purchased.)
In this case, you’ve invested a total of $5,000 and now have a vehicle worth $18,000, making a profit of $13,000. Of course, you probably won’t sell your car to cash in on these profits but for the sake of this example, it helps to highlight the potential gain on this transaction, even if it is unrealized. It works similarly in the world of securities but the goal is, more often than not, to preserve the underlying asset and net profits in your portfolio.
The main point is that you are trying to protect an asset whose loss of value is subject to events you may not have control over. To hedge against loss, you pay a premium, known as the price of the put option, to protect yourself from losses should your asset lose value.
Conversely, as a seller of a put, you are like the insurer in this example. Imagine the insurer insured 100 other drivers with the same demographics, cars, risk factors, etc. at $900 for the year, making the break-even point five accidents at $18,000 for the year. As long as there are fewer than five accidents, the insurer stands to make between $90,000 (no accidents) and $72,000 (four accidents) on premiums.
It’s also helpful to know that options can be traded on their own markets. If you plan to trade options, your interest lies more in the fluctuation of the price of the insurance premium based on demand generated in the fictitious market where these insurance policies are sold, (though insurance-linked securities and markets do actually exist.)
Like trading in any market, you are speculating on the nature of the price change of the insurance policy. Your goal is to earn a profit, buying or selling insurance premiums, despite the fact that you’ll never own the car insured by the police nor take part in any transaction to sell it once it’s totally replaced by the insurance payout.
An example of a put option
Let say that you have a stock that is priced at $50, but you believe the price may drop to $40 in the near future. You can purchase a $45 put option for 20 cents. Should the stock drop to $40, you have the right to sell at $45 even though it’s trading at $40. In this scenario, you’d net a $4.80 profit on each share.
Also, the seller of the put would have to buy the stock from you at $45, a $4.80 loss per share. However, if the stock never drops below $45 by the expiration date, the put buyer loses 20 cents per share and the put seller keeps the 20 cents per share as a profit.
Call option vs put option
Another type of option is known as a call option. A call option gives the buyer the right, but not the obligation, to buy the underlying security at the strike price by the expiration date. In this case, you stand to make a profit when the price of a stock increases. Like put options, you can own the underlying asset linked to the option or simply buy or sell the call option.
Why would you buy put options?
The main reason for buying put options as an investor is to hedge against losses. If you are concerned about a down market eating into your gains or negatively affecting the performance of your portfolio, put options could give you some peace of mind to close out positions as the market experiences a downturn.
You’d sell put options to earn a profit on the premium you collect writing the options contract. If you write a contract for 100 shares of stock at $20 each and the stock stays above the strike price, you stand to make between $0 and $2,000, depending on where the price settles before your contract expires.
You can trade options with less of an initial investment (i.e. the price of the premium versus the price of 100 shares of the actual stock.) However, the downside is that you could experience more losses if your predictions about price movements don’t pan out within the time frames in your contract.
How to start options trading
Like buying and selling stocks, you can access call and put options within a basic trading platform or online broker. Some platforms may require an application to access this trading option. Depending on the platform, there may be requirements you must meet in terms of liquidity (available cash) and trading experience.
There are plenty of online platforms where you can practice trading in a simulated environment. You can even create mock investment portfolios until you are ready to use real money.
Once you’re ready to purchase put options, you can choose the parameters of the put option that include:
Premium (if you are selling the option)
Number of contracts
From here, you’ll watch the price of the stock and decide to exercise (or not) your option to buy or sell your calls and puts before the expiration.
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