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What is a put option?

What is a put option?

A put option gives the owner of the option/contract the right to sell a stock at the strike price named in the contract.

One kind of option is a put. A Put is a right to sell a particular asset (usually a stock) at a certain price (called the “strike price”) within a specified time-frame. The owner of the put contract doesn’t need to own the underlying stock.

If the price of the stock drops below the strike price in the put, the owner of the put contract can buy the stock at the lower market price and immediately sell it at the higher strike price in the put contract. That is a speculative way to use a Put contract.

On the other hand, let’s say you own 100 shares of ABC, and each share is worth $100. You actually bought these 100 shares a few years ago at $50/share, and you want to protect your profits. A put option can give you that protection if you buy a contract with a strike price below the current market price of the stock, but higher than the price you paid for it.

For example, you might buy a put valid for the next three months, which allows you to sell the shares of ABC at $90/share. You might pay $5 per share for such a put. It is worth noting that the price of options is quoted on a per-share basis, but each put or call contract will be for a quantity of 100.

If the stock goes below $90/share during the next three months, you can exercise your right to sell the stock for $90, and you will receive $9000, for a net of $8500 once you subtract the cost of the put contract ($500). If, however, the stock does not go below $90 during the next three months, you lose the $500 premium you paid for the Put.

This is very similar to buying car insurance: you pay the premium, but if you don’t have any accidents, the insurance premium is “wasted.” An alternative to using put contracts as a hedge is putting a stop-loss or stop-limit order on your stock so that if they go below a certain price, it triggers a sale of your shares.

Puts give you more control over the final sale price, of course, but stop orders do not require a premium to be put in place. Another side of put options is that there is an individual or institution on the other side of the contract who has “written” the option.

They collect premiums from those who buy the contracts. If the options expire worthless, the writer has made money. If the puts are exercised, the writer will be obligated to buy the underlying stock from the owner of the put contract at whatever the strike price is.

Keywords: portfolio management, hedging, stop-loss, calls, puts, options, stop-limit, writing puts,
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