Put Option: What It Is, How It Works, and How to Trade Them

What Is a Put Option?

A put option (or “put”) is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame. This predetermined price at which the buyer of the put option can sell the underlying security is called the strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying security at a specified price, either on or before the expiration date of the option contract.

How a Put Option Works

A put option becomes more valuable as the price of the underlying stock or security decreases. Conversely, a put option loses its value as the price of the underlying stock increases. As a result, they are typically used for hedging purposes or to speculate on downside price action.

Investors often use put options in a risk management strategy known as a protective put, which is used as a form of investment insurance or hedge to ensure that losses in the underlying asset do not exceed a certain amount. In this strategy, the investor buys a put option to hedge downside risk in a stock held in the portfolio. If and when the option is exercised, the investor would sell the stock at the put’s strike price. If the investor does not hold the underlying stock and exercises a put option, this would create a short position in the stock.

Factors That Affect a Put’s Price

In general, the value of a put option decreases as its time to expiration approaches because of the impact of time decay. Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade. When an option loses its time value, the intrinsic value is left over. An option’s intrinsic value is equivalent to the difference between the strike price and the underlying stock price. If an option has intrinsic value, it is referred to as in the money (ITM).

Out of the money (OTM) and at the money (ATM) put options have no intrinsic value because there is no benefit in exercising the option. Investors have the option of short-selling the stock at the current higher market price, rather than exercising an out-of-the-money put option at an undesirable strike price. However, outside of a bear market, short selling is typically riskier than buying put options.

Time value, or extrinsic value, is reflected in the premium of the option. If the strike price of a put option is $20, and the underlying is stock is currently trading at $19, there is $1 of intrinsic value in the option. But the put option may trade for $1.35. The extra $0.35 is time value, since the underlying stock price could change before the option expires. Different put options on the same underlying asset may be combined to form put spreads.

There are several factors to keep in mind when it comes to selling put options. It’s important to understand an option contract’s value and profitability when considering a trade, or else you risk the stock falling past the point of profitability.

The payoff of a put option at expiration is depicted in the image below:

Where to Trade Options

Put options, as well as many other types of options, are traded through brokerages. Some brokers have specialized features and benefits for options traders. For those who have an interest in options trading, there are many brokers that specialize in options trading. It’s important to identify a broker that is a good match for your investment needs.

Alternatives to Exercising a Put Option

The buyer of a put option does not need to hold an option until expiration. As the underlying stock price moves, the premium of the option will change to reflect the recent underlying price movements. The option buyer can sell their option and either minimize loss or realize a profit, depending on how the price of the option has changed since they bought it.

Similarly, the option writer can do the same thing. If the underlying price is above the strike price, they may do nothing. This is because the option may expire at no value, and this allows them to keep the whole premium. But if the underlying price is approaching or dropping below the strike price, then to avoid a big loss, the option writer may simply buy the option back (which gets them out of the position). The profit or loss is the difference between the premium collected and the premium paid to get out of the position.

Example of a Put Option

Assume an investor buys one put option on the SPDR S&P 500 ETF (SPY), which was trading at $445 (January 2022), with a strike price of $425 expiring in one month. For this option, they paid a premium of $2.80, or $280 ($2.80 × 100 shares or units).

If units of SPY fall to $415 prior to expiration, the $425 put will be “in the money” and will trade at a minimum of $10, which is the put option’s intrinsic value (i.e., $425 - $415). The exact price for the put would depend on a number of factors, the most important of which is the time remaining to expiration. Assume that the $425 put is trading at $10.50.

Since the put option is now “in the money,” the investor has to decide whether to (a) exercise the option, which would confer the right to sell 100 shares of SPY at the strike price of $425; or (b) sell the put option and pocket the profit. We consider two cases: (i) the investor already holds 100 units of SPY; and (ii) the investor does not hold any SPY units. (The calculations below ignore commission costs, to keep things simple).

Let’s say the investor exercises the put option. If the investor already holds 100 units of SPY (assume they were purchased at $400) in their portfolio and the put was bought to hedge downside risk (i.e., it was a protective put), then the investor’s broker would sell the 100 SPY shares at the strike price of $425.

The net profit on this trade can be calculated as:

[(SPY Sell Price - SPY Purchase Price) - (Put Purchase Price)] × Number of shares or units

Profit = [($425 - $400) - $2.80)] × 100 = $2,220

What if the investor did not own the SPY units, and the put option was purchased purely as a speculative trade? In this case, exercising the put option would result in a short sale of 100 SPY units at the $425 strike price. The investor could then buy back the 100 SPY units at the current market price of $415 to close out the short position.

The net profit on this trade can be calculated as:

[(SPY Short Sell Price - SPY Purchase Price) - (Put Purchase Price)] × Number of shares or units

Profit = [($425 - $415) - $2.80)] × 100 = $720

Exercising the option, (short) selling the shares and then buying them back sounds like a fairly complicated endeavor, not to mention added costs in the form of commissions (since there are multiple transactions) and margin interest (for the short sale). But the investor actually has an easier “option” (for lack of a better word): Simply sell the put option at its current price and make a tidy profit. The profit calculation in this case is:

[Put Sell Price - Put Purchase Price] × Number of shares or units = [10.50 - $2.80] × 100 = $770

There’s a key point to note here. Selling the option, rather than going through the relatively convoluted process of option exercise, actually results in a profit of $770, which is $50 more than the $720 made by exercising the option. Why the difference? Because selling the option enables the time value of $0.50 per share ($0.50 × 100 shares = $50) to be captured as well. Thus, most long option positions that have value prior to expiration are sold rather than exercised.

For a put option buyer, the maximum loss on the option position is limited to the premium paid for the put. The maximum gain on the option position would occur if the underlying stock price fell to zero.

Writing Put Options

In the previous section, we discussed put options from the perspective of the buyer, or an investor who has a long put position. We now turn our attention to the other side of the option trade: the put option seller or the put option writer, who has a short put position.

Contrary to a long put option, a short or written put option obligates an investor to take delivery, or purchase shares, of the underlying stock at the strike price specified in the option contract.

Assume an investor is bullish on SPY, which is currently trading at $445, and does not believe it will fall below $430 over the next month. The investor could collect a premium of $3.45 per share (× 100 shares, or $345) by writing one put option on SPY with a strike price of $430.

If SPY stays above the $430 strike price over the next month, the investor would keep the premium collected ($345) since the options would expire out of the money and be worthless. This is the maximum profit on the trade: $345, or the premium collected.

Conversely, if SPY moves below $430 before option expiration in one month, the investor is on the hook for purchasing 100 shares at $430, even if SPY falls to $400, or $350, or even lower. No matter how far the stock falls, the put option writer is liable for purchasing the shares at the strike price of $430, meaning they face a theoretical risk of $430 per share, or $43,000 per contract ($430 × 100 shares) if the underlying stock falls to zero.

For a put writer, the maximum gain is limited to the premium collected, while the maximum loss would occur if the underlying stock price fell to zero. The gain/loss profiles for the put buyer and put writer are thus diametrically opposite.

The Bottom Line

Put options allow the holder to sell a security at a guaranteed price, even if the market price for that security has fallen lower. That makes them useful for hedging strategies, as well as for speculative traders. Along with call options, puts are among the most basic derivative contracts.