In this Beginner’s Guide to Options Trading series, I am covering basic option concepts in their most simple form. Check out the first article in the series which provides a general options overview. This article will go over the important concepts specifically behind buying put options.
Put Options Explained
The put option gives the buyer the right to sell 100 shares of stock at the strike price on or before the expiration date to the put option seller. The buyer can choose to execute this right at any point in time up to the close of the market on the expiration date. The seller of the put option is obligated to buy the shares if this happens. The put seller simply has no say in the matter.
Buying a Put Option Example
In this picture we are looking at the SPY options table expiring on Feb 17, 2023. For the purposes of this example, let’s buy the $395 strike put option for $7.29 a share. The current price of SPY is $395.88. Buying this put gives the right to sell 100 shares of SPY at $395 per share. We paid $729 for this right to sell shares of SPY before Feb 17, 2023.
How do Put Option Buyers Make Money?
Stated simply, put option buyers make money when the stock’s price goes down. Take time to think about this.
When you bought the $395 put, you bought the right to sell the stock at $395 to someone else. If the stock price goes up to $400, you’d much prefer to sell the stock at $400 rather than $395. On the other hand, if the stock goes down to $390, you’d be able to sell shares at $395! This is the “sell high” part of the old adage, “buy low and sell high.”
Why Would You Buy a Put Option?
There are several specific reasons why you might buy a put option but the fundamental belief is that the price of the stock will go down in the near future.
A bought put is a way to short stock without owning shares.
A bought put can hedge, or protect, 100 shares of stock that you already own from a price decrease.
A bought put can be combined with other options as one component of a more complex strategy
I mention these ideas here so that you are introduced to these concepts. Other articles will be dedicated to these and many other strategies. Since this is a basics article, we will go no deeper here.
Back to our Long SPY 395 Put Example
Imagine a scenario where SPY fell to $380 a share on Feb 17, 2023. How are you feeling about your put option that you bought? You should be happy for your winning trade! Using this as an example, we will discuss the three choices you have as an option buyer. Keep in mind that these three choices exist at any point between buying the option and the option’s expiration.
Exercise the option
Close the position
Do nothing
Exercising a Put Option
To exercise a put option, you start by notifying your stock broker and the rest will be carried out by them. Behind the scenes, the broker sells 100 shares of stock from your account to the person who sold you the option. The proceeds of the sale go directly into your account. If you happened to not have 100 shares of stock in your account, your broker would still sell the shares, but you’d be “short” 100 shares of stock.
What does “short” stock mean?
Short stock means you are in “debt” shares of stock but plan on buying some in the future to pay off the debt. To illustrate this, forget stocks for a second. Jack and Alan are friends going out to lunch at a fast food restaurant. Jack orders his food and steps aside. Alan orders, but realizes that he left his credit card at home. He bought $10 worth of food but only has $5 in cash in his wallet. Alan says to Jack, “Hey Jack, can you spot me some money, I’m $5 short.” Jack, being a good friend, paid the balance for Alan. Alan is effectively short $5 to Jack who expects to be paid back at some point in the future.
Back to our Example
The current price is $380 and you own a put option that allows you to sell the stock at $395. Keep in mind you paid $7.29 at the beginning of the trade to buy this option. When you exercise the put, you are exercising the terms of the contract and sell the 100 shares to the option seller for $39,500. You would now be short 100 shares of SPY. If you were to buy 100 shares of SPY at the current price of $380 to cover the short, this would cost $38,000. This nets a profit of $1,500 ($39,500 from the sale - $38,000 from buying back the shares). Subtracting the initial debit paid of $729 leaves you with an overall profit of $771!
Sell to Close the Put Option
Closing a position is a simple way of saying “getting back to zero.” Another term people use is “flattening” the position. If you buy 100 shares of stock, you will have +100 shares in your account. To close the position, you need to get back to zero shares. To accomplish this, you just sell the 100 shares. If you’ve gone short 100 shares, your account will show -100 shares. To get back to zero, you must buy 100 shares. This same concept applies to options.
When an option moves in the desired direction, it becomes more and more valuable. The math behind this is well beyond the scope of this article, but we can look at this conceptually. If the price of SPY is $380, how much money would you pay to immediately be able to sell it to someone else for $395? Probably somewhere close to but less than $15. If you paid more than $15, you’d be guaranteed to lose money. Paying less than $15 means you’d make money on the transaction. The other factors that go into the equation, such as time and volatility, impact that ultimate price but this is all calculated by your broker.
In our example, if the price is $380 on the day of expiration, the $395 put option you bought will likely be worth somewhere close to $15! For easy math, let’s say it’s worth $14.79. Because you bought the option, you must sell it to close the position.
$14.79 of income from selling back the option – $7.29 debit when buying the option = $7.50 profit.
Recall that this is per share, so this results in a $750 total profit.
Do Nothing
With options, the market’s close on the option's expiration date is the definitive end of the trade. If you choose to do nothing it comes down to the option being “in the money” or “out of the money” at expiration.
Example of a Put Option Expiring In the Money
We bought the $395 put in SPY. If on expiration, the price of SPY were $394.99 or less, then this put would be considered ITM, or in the money. When an option expires ITM, something will happen to your account. This “something” typically means that the option terms will be executed by your broker automatically. The broker does this because it is the most profitable outcome for you at that moment. By executing the contract, the broker would sell 100 shares of SPY at the strike price of $395 and would deposit the $39,500 in proceeds in your account. Since the price of SPY is less than $395, you could buy 100 shares of SPY for less than a total of $39,500. The difference is your profit.
Example of a Put Option Expiring Out of the Money
If we buy a put, the price is considered out of the money, or OTM, if the price is above the strike price. In this example, we bought the $395 put on SPY. If, on expiration, the price were $395.01 or higher, then this put is considered OTM. Options that expire OTM are essentially worthless. For a bought put, the broker would simply remove the option from your portfolio. It wouldn’t make sense for the broker to execute the contract since this would create a loss on top of the loss of the initial premium paid.
Wrapping Up
The fundamental idea behind buying a put option is that you believe the stock price will go down in the near future. Buying a put allows you to sell 100 shares of stock to someone at the strike price, for the cost of the premium you paid. If your bearish assumption is correct, the put option will gain value because you have the right to sell the shares at a price higher than you can buy them back for.
Check out these other articles in GKT’s Beginner’s Guide series if you want to learn more!
Beginner’s Guide to Selling Call Options
Beginner’s Guide to Buying Put Options - That's this article!
Beginner’s Guide to Selling Put Options
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