Buying a put is the opposite of buying a call.
In contrast to buying a call option a put is essentially placing a bet that a stock will go down in value under a certain price by a certain date. Just like with call options that price is called the ‘strike’ and the date is called the ‘expiration date’. Unlike calls, the purchaser of a put has the right, but not the obligation, to sell 100 shares per contract of the underlying stock at the strike price to the writer/seller of the put. The only requirement is that the stock price is at or under the strike price before or on expiration. That period of time can be as short as 1 day or as long as 2 years. The more time before expiration the more the option will cost since more time equals greater opportunity for the stock price to change in the investors favor. This is called ‘time value’.
Like calls, puts are risky. If the stock price does not decrease sufficiently before expiration then you lose all your investment. Unlike calls however, profit potential is not infinite since a stock cannot go beneath $0. BUT, compared to shorting a stock puts are far less risky since the most you can lose is your entire investment. When you short on a stock the loss potential is infinite since a stock can go up infinitely and as it goes up you lose more and more money. Read this man’s story before you consider shorting a stock. Long story short (no pun intended) he woke up one morning and owed E-Trade $106,445 dollars. For this reason we recommend buying puts over short selling.
There’s two ways you can profit from a put option
- Resell the put for a profit if the stock price decreases sufficiently before expiration
- Exercise your right to sell 100 shares of the underlying stock to the writer of the put at the strike price. You make a profit because the stock price will be under the strike price meaning you can buy the shares for a cheaper price than you sell them.
Let’s discuss the terminology you’ll need to understand before buying put options and then look at an example.
Option value = intrinsic value + time value
- Option- A contract between the purchaser and seller of that gives the investor the right, but not the obligation (i.e. the option) to buy 100 shares of the stock at the strike price for every contract owned.
- At the money (ITM)- A call option is ‘at the money’ when the share price of the stock is equal to or greater than the strike price. In order for the call to be profitable at expiration the stock must trade for a price greater than the strike price such that your profit from reselling the option or exercising the option and selling the shares is greater than the premium paid to buy the option contracts.
- Out of the money (OTM)- When the share price of the stock is less than the strike price and the option has no intrinsic value.
- Time decay- Describes the progressive decrease in value of an option due to less and less time for the stock price to change as the expiration date approaches.
- Intrinsic value- The value of an option if it were to be exercised assuming it’s in the money. An options intrinsic value increases the farther above the strike price it is.
- Premium- The price/cost an investor pays to purchase an option. The farther out of the money and the less amount of time before expiration the less the premium is.
- Break-even point- The price at which you break even at the expiration date. This price is always above the strike price because you must be able to exercise and sell the shares for a profit equal to the premium paid.
- Writer- The person or institution that sells or ‘writes’ the option contract.
Example: Buy 5 put contracts of Conatus Pharmaceuticals (NASDAQ: CNAT) at a $5.0 strike price expiring on January 18th 2019.
To buy 5 put contracts at a $5 strike expiring on January 18th, 2018 would cost $199 per contract ($199 is the cost between the bid and ask that you end up paying).
Total price= 5*$199 + $20 commision= ~$1015 dollars
The breakeven price at expiration would be ~$3.05 at expiration. Max loss would be $1015. Max return would be ~$1800 at a price of $.05/share.