Rick is a Wall Street Journal bestselling author with over 20 years of experience trading stocks and options. He has appeared on Good Morning America and its rival, Today, and the most authoritative publications covering his work include Business Ins.
Rick Orford Investing Expert WriterRick is a Wall Street Journal bestselling author with over 20 years of experience trading stocks and options. He has appeared on Good Morning America and its rival, Today, and the most authoritative publications covering his work include Business Ins.
Written By Rick Orford Investing Expert WriterRick is a Wall Street Journal bestselling author with over 20 years of experience trading stocks and options. He has appeared on Good Morning America and its rival, Today, and the most authoritative publications covering his work include Business Ins.
Rick Orford Investing Expert WriterRick is a Wall Street Journal bestselling author with over 20 years of experience trading stocks and options. He has appeared on Good Morning America and its rival, Today, and the most authoritative publications covering his work include Business Ins.
Investing Expert Writer Lisa Dammeyer Deputy Editor, Investing & RetirementWith more than six years' experience an editor, investing specialist Lisa Dammeyer brings a keen eye for detail and fact-checking chops to everything she works on. Her work over the past four years at various financial publications has helped investo.
Lisa Dammeyer Deputy Editor, Investing & RetirementWith more than six years' experience an editor, investing specialist Lisa Dammeyer brings a keen eye for detail and fact-checking chops to everything she works on. Her work over the past four years at various financial publications has helped investo.
Lisa Dammeyer Deputy Editor, Investing & RetirementWith more than six years' experience an editor, investing specialist Lisa Dammeyer brings a keen eye for detail and fact-checking chops to everything she works on. Her work over the past four years at various financial publications has helped investo.
Lisa Dammeyer Deputy Editor, Investing & RetirementWith more than six years' experience an editor, investing specialist Lisa Dammeyer brings a keen eye for detail and fact-checking chops to everything she works on. Her work over the past four years at various financial publications has helped investo.
| Deputy Editor, Investing & Retirement
Published: May 21, 2024, 11:25am
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Options trading allows investors to speculate on the price movement of a particular security or the overall market. Although many investors think options are complicated, if you understand the basics, they are not as convoluted as they appear.
Put options allow an investor to sell a particular security for a set price before a particular date. However, before employing put options in your trading arsenal, you need to know both how they work and how you can use them to your advantage.
A put option is a virtual contract offering the holder the right to sell an asset for a specific price before the contract expires.
Put options specify four things:
Investors who buy put options typically use them as a form of insurance to protect against a loss in the underlying security strike price. Each put option contract represents 100 shares in the underlying security and is valid until its expiration date.
Let’s say, for instance, you own 100 shares of XYZ Corporation in your portfolio and would like to protect it against a drop in price. Maybe you feel the price is currently too high, but you don’t want to sell it and trigger a capital gain.
Or perhaps you are bullish on the company in the long term but want to protect yourself against short-term market noise—perhaps you’re susceptible to a margin call. In both cases, you could profit from a put option if the stock drops below the strike price by expiration.
Put options give an investor the right to sell an underlying security at any time until expiration.
On the other hand, call options offer investors the right to buy the underlying security at any point until expiration.
Put options give the holder the right—but not the obligation—to sell the underlying security at any time before expiration. Typically, the holder will do so only if it’s profitable.
When it comes to options in general, investors consider the individual option’s “moneyness.” “In the money” means the option has intrinsic value, while “at the money” or “out of the money” options have no intrinsic value.
Let’s say, for example, you buy a put option on XYZ Corporation with a $100 strike price that expires in one month.
If XYZ Corporation trades around $110 today and the premium for this option is $3, then this is an out-of-the-money option. It has no intrinsic value. The premium is the price the investor must pay, times 100, which buys one option contract.
In other words, the total premium you’re paying for XYZ Corporation today is $300.
Should XYZ Corporation trade below $97 at any time before expiration, your trade would become profitable. Did you notice how we said $97 and not $100, which was the original strike price of the option you purchased?
That’s because to calculate the breakeven price on a long put option, you must subtract the premium from the strike price.
If XYZ Corporation does indeed trade below $97 before the put option expires, you could either exercise the option and sell 100 shares of XYZ Corporation for $100 each, or you could sell the option—whichever results in more profit for you.
On the other hand, should XYZ Corporation trade above $100 by expiration, which is the strike price of this option, the option will be worthless and result in a $300 loss for you per purchased contract.
Several factors dictate the price of a put option. The most important ones are:
Investors holding put options and wanting to exercise them need only request that action from their brokerage.
Some platforms allow investors to do this online, while other brokerages may require a written request or a phone call.
Buying and selling put options require prior authorization from your brokerage. For options trading, there are four levels of authorization.
Buying put options typically requires a “Level 2” trading level, while selling puts typically requires a “Level 3” authorization. In the United States, options trading at Levels 1, 2 and 3 can be authorized in either a cash or IRA account. Only Level 4 requires a margin account.
The higher the level, the higher the risk to you and the brokerage. Expect the brokerage to ask questions about your assets and trading experience before authorizing access.
Once the brokerage authorizes the trading level, investors can buy and sell options within their online trading platform. To purchase a put option, an investor will initiate a “buy to open” order, while an investor looking to sell a put option will initiate a “sell to open” order.
Then, the investor will select the underlying asset and strike price. A premium will populate, and the investor can choose either a market order or set a limit price.
Limit orders are recommended to ensure there are no surprises when the order is filled. For example, if the option’s price suddenly changes and you’re about to lose money, a limit order can keep your brokerage from executing the trade.
Buying a put option is a bearish trade. In other words, you’re betting the price of the underlying security will go down. Investors typically buy put options when they believe in the company’s long-term prospects but want to protect themselves from any short-term paper losses.
Investors looking to protect themselves from short-term price drops in a specific equity may buy a put option on the stock. Alternatively, investors can protect their portfolio by buying a put option on an index-based exchange-traded fund, like the SPDR S&P 500 ETF (SPY) or Invesco QQQ ETF (QQQ).
As opposed to buying put options, selling put options is a bullish trade. You’re betting that the price of the underlying security will go up. A put option seller is said to be short and profits when the option expires worthless. Investors often sell put options to generate income in return for exposure to any downside in pricing.
That said, while selling puts is often seen as a “risky” trade, it is no more risky than owning 100 shares of the stock outright, times the number of contracts sold.
There are no real alternatives to put options, but there are similar tools an investor can use.
Short selling, for example, is sometimes seen as an alternative to buying a put option. However, short selling comes with, theoretically, unlimited risk. Unlike with put options, there’s no cap on how much you could potentially lose when shorting a stock.
Short sellers profit when the stock goes down in price and lose money when the stock goes up. A famous example of this was the popularity of GameStop (GME) during the Covid-19 pandemic. Melvin Capital, a famous hedge fund, lost billions on its GME short position—thanks to so-called meme investors from the now infamous subreddit r/WallStreetBets.
Because of the risk involved, be sure to do your due diligence before engaging in short selling.
Trading options is a speculative game that works only when the investor is correct in their thesis. If you believe a stock is going down and you hold a put option on it, you might turn a profit. Similarly, a seller profits when the stock goes up and their options expire out of the money.
The key to becoming a successful options trader is to know your chances of success. Some brokerages provide this information, but many do not—so it is important to pick the right brokerage and do your research before trading options.
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