What is a Put Option?

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Definition:

Buying a put option means opening a contract that gives you the right, but not the obligation, to sell shares of a stock at a certain price (the “strike price”) up until a set date (“expiration date”).

🤔 Understanding put options

Buying a put option gives a person the right, but not the obligation, to sell a financial instrument at a predetermined price, called the strike price. The potential to sell remains available until the contract’s expiration date. Put options are a way for investors to bet against a stock, commodity, or other financial instrument, as well as one way to hedge their investments. When you buy a put option, you are long a put. When you sell a put option, you are short a put. The opposite of a put option is a call option, which gives its owner the right, but not the obligation, to buy an instrument.

Example

Let’s say you buy a put option for 100 shares in the fictional company Peter’s Cookware. The contract has a strike price of $20, and you pay a premium of $1 per share (or $100 total) for this right. Stock in Peter’s Cookware is currently trading at $25 and you expect it to fall. If your expectation is correct and the price of the stock falls below $20 — let’s imagine it drops to $18 — you may exercise your put option. In this scenario, you may earn a net profit of $1 per share or $100 total (that’s a $2 gain per share minus $1 in premium per share, and it doesn’t factor in any fees). However, if the stock doesn’t move as you expected, your put option may expire worthless, meaning that you could lose the premium you paid ($1 per share, or $100 total).

Takeaway

A put option is kind of like an insurance policy on your car…

You pay a small premium, and in exchange, if you get into an accident, you’ll be reimbursed for some or all of your repair costs. Unlike real insurance policies, with put options, you don’t have to own the car to take out an insurance policy.

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What does it mean to buy a put option?

Buying a put option means that you have the right, but are not required, to sell a security at a specified price for a set time. This is called being long a put. If the security drops in price, it is likely that the put option will increase in value, but that’s not always the case.

How does a put option work?

Let’s say that a stock is currently trading at $4 per share. If you read that the company is facing a lawsuit and you think its share price is going to fall soon, you might buy a put option. Here are three important terms:

The strike price is what you can sell the shares for. If the stock price falls below the strike price, you may make money on the option. In this example, let’s imagine the strike price is $3.50 per share.

The expiration date is the last day you can exercise the option. If the stock price falls below the strike price before the option expires, you could potentially profit. If it doesn’t, the option will expire worthless. In this case, let’s assume the contract expires in 30 days.

The premium, or option price, is how much you pay the seller of the option for the contract. In this case, let’s say the option price is $0.10. So you pay $10 for the long put (that’s $0.10 x 100 share contract multiplier).

Owning this contract gives you the right, but not the obligation, to sell 100 shares in this company for $3.50 per share at any point before the expiration date. If the month goes by and the stock price of the company never goes below $3.50, you could possibly sell the option back at a lower price than $0.10, but it would depend on if there was a willing buyer. In this case you would realize a loss on the option. The other choice would be to let the contract expire. In this case, your option ends up costing you the $10 premium (plus any commissions or fees for the broker). But you don’t have any obligation to do anything.

But if at any point in the month the value of your put option increases, you have an opportunity to make some money. Let’s imagine a scenario where the stock price falls below $3.50. This would likely lead to an increase in the value of your put option. For example, if shares in the company fell below $3.50, the value of your put option may increase. If your put option was now trading at $1.00, you could potentially sell it for a profit of $0.90 per share ($1.00 current value - $0.10 premium paid = $0.90 profit on the option). Overall, that would be a gain of $90 dollars.

Why would a person buy a put option?

You usually invest because you believe in the product or the company. You may think the company will grow as more people learn about the product, or as the company releases new product lines. But, every once in a while, you might think a company is a dog (a bad company) and that the market price of the company is above what you believe it is worth. Since you expect the price of the stock to fall, you don’t want to purchase it. But you could try to profit off your insight.

Believing that the stock price is heading downward, you may purchase a put option. Buying that option gives you a certain amount of time to potentially profit if the stock goes down.

Alternatively, let’s say that you own shares of stock in a company you like. You would prefer not to sell them, but you’re nervous the stock might be ready to decline in price. Maybe a new product is launching and you’re not sure if it’ll be a success. If it is successful, the value of the company may go up. But if it’s a mess, you might expect the price of the underlying stock to fall.

In this situation, buying a put option doesn’t mean you are betting that the company is overvalued. Instead, you may want to put a net under your feet (this would be called a protective put). If the company is currently trading at $100 a share on the stock market, and you think there’s a chance that the stock will fall to $70 a share, you may help protect your position with a put option. Perhaps you buy a put option that allows you to sell your shares at $80 a share. Then, if the price falls below $80, you are still guaranteed that price for a set period of time.

In this instance the put option functions sort of like an insurance policy against a steep decline in value. If things work out and the price stays above $80, you don’t have to worry about anything. You could just let the option expire. Keep in mind, the premium you paid for the option would technically eat into your stock profits, but as with any insurance policy, it would be a tradeoff you were willing to make.

Put options work this way for more than just stocks. You can buy them for corporate bonds, banknotes, commodity futures, currency exchange contracts, index funds, exchange-traded funds (ETFs), derivatives, and other financial instruments that experience price movements.

A put option is simply the right to sell any of these securities at a predetermined price for a specified length of time. Buying and selling options rather than the underlying stock is known as options trading. There are several strategies used by option traders, and a put option is one tool in the toolkit.

What is the difference between call options and put options?

While owning a put option gives you the right to sell a security, owning a call option gives you the right to purchase a security. In either case, you are under no obligation to buy or sell anything. The contract just gives you the option to do so if the conditions are right within the specified time frame.

You may purchase a call option if you think the price of something will go up. You may purchase a put option if you think the price of something will go down.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Examples are hypothetical, and do not reflect actual or anticipated results, and are not guarantees of future results.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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