What is a Put Option?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

Buying a put option gives someone the right to sell something in the future for a preselected price during a specified period.

🤔 Understanding put options

Buying a put option gives the holder the right to sell a financial instrument at a predetermined price, called the strike price. The opportunity to sell stays open until the expiration date. Put options are a way for investors to bet against a stock, commodity, or other financial instrument, as well as to hedge their investments. When you buy a put option, you are long a put. When you sell a put option, or are short a put, you might be hoping to buy the underlying security at a lower price or collect the premium for as long as the security is above the strike price. The opposite of a put option is a call option, which gives the holder the right to buy an instrument.

Example

On February 3, 2020, Disney shares closed at $141.32. If you believe the future of entertainment was virtual reality, you might think that people could stop going to Disney theme parks, booking trips on Disney cruises, and going out to watch Disney films. All of those ideas point to a falling stock price.

One way to take advantage of your insight would be to purchase a put option on Disney stock. Let’s say you think the stock price will fall below $130 within the next year. Someone could sell you a put option, at a premium of $3 per share, giving you the right to sell Disney stock at $130. The contract would be for 100 shares and it would expire in twelve months.

Your long put would cost you $300 to purchase and would give you the right to sell the 100 shares of Disney stock for a total of $1,300. If the stock falls to $120 per share, you would be $10 in the money. At that point, you could exercise the option and make $1,000 on the option. Subtract the $300 premium, and you’ve earned a profit of $700.

If you believe the prospects of Disney are good, one way to take advantage is to purchase a call option.

Takeaway

A put option is like speculating that your lemon tree will wilt and die....

Let’s say you plant some lemon seeds and are trying to grow a tree. Maybe you aren’t too confident in your gardening abilities and think that your tree will wither and won’t produce any fruit – This is kind of like buying a put option. Alternatively, maybe you have a green thumb and think that your tree will grow abundantly and produce many lemons – This is like buying a call option.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
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.

Tell me more…

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 starts trading below the set price, called the strike price, you can exercise your right and sell the security to the option seller.

How does a put option work?

Let’s say that an agribusiness stock is currently trading at $4 per share. If you heard that the company is getting sued for using the wrong pesticides and think the price is going to fall soon, you might buy a put option in those shares. The option has 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 case, let’s set the strike price at $3.50 per share for 100 shares of the agribusiness.

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 win. If it doesn’t, you just let the option expire. 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 per share. So you pay $10 for the long put.

This contract means that you can sell 100 shares in this company at any point before the expiration date. The person on the other end of the contract will pay you $350 (100 shares at $3.50 each). In exchange, you would provide the 100 shares in the company.

If the month goes by and the stock price of the company never goes below $3.50, you would just let the contract expire. The 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 price falls below $3.50 per share, you have an opportunity to make some money. In financial jargon, the option is “in the money.” Say the price drops to $3.25 while your option is open. All you have to do is buy 100 shares at $3.25 apiece, then exercise your right to sell them at $3.50 per share.

When the dust clears, you ended up paying $325 for the stock (100 shares at $3.25 each), and then sold it for $350. That’s a gain of $25 on the deal. Subtract $10 for the premium, and you ended up with $15 in profit, excluding any trading fees. In this scenario, the option is said to be "in the money," and the $25 of value above the strike price is called the intrinsic value of the option. In theory, the maximum profit you could make from this long put would happen if the stock price went to zero. Therefore, the maximum gain is the strike price minus the option price.

Why would you buy a put option?

You usually buy an investment 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 and that the market price of the company is above what 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 can seek out a put option. Buying that option gives you a certain amount of time to sell the stock for a fixed amount below where it’s trading on the market. If you’re right, you could wait for the price to crash, sweep up enough discounted shares to fill your option, and sell them at a profit. In this way, you can create profit potential even in a declining market.

Alternatively, let’s say that you own shares of stock in a company you like. You would prefer not to sell them, but you are nervous about something happening. Maybe a new product is launching and you’re just not sure if it will be a success. If it is successful, the value of the company will go up and the share price should rise. But if they mess up the roll-out, you might expect the price of the underlying stock to fall.

In this situation, buying a put option doesn’t mean you are betting on the fact that the company is overvalued. Instead, you may just want to put a safety net under your feet (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 can 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. It acts 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’d just let the option expire.

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

You would usually purchase a call option if you think the price of something will go up. A put option is the opposite — you would want to have a put option in place if you believe the price will go down. Buying options lets you take advantage of being right while limiting the consequences of being wrong.

You could purchase the stock of a company that you think is heading up. But then you bear the consequences if the price falls. A call option lets you cash in if the stock price does go up, but you only lose the price you paid for the option if the stock drops.

Likewise, you could short a stock that you think is heading down. But if you’re wrong, you could be on the hook for a lot of money as the price moves higher. With a put option, you cash in if you’re correct and let the contract expire if you're not — your loss is limited to the premium you paid for the right to sell.

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.

Ready to start investing?
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.

1334165

Related Articles

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2020 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1200251