Beginning options investors often struggle with the concept of put options. They have no trouble with call options.
With calls, beginners usually grasp that you will buy a predetermined number of shares in the future. The expiration date is also decided ahead of time.
Puts, on the other hand. give the holders of shares the right to sell shares. The concept seems to imply that investors sell shares they do not own.
As will be described below, this is not the case.
Whether you are buying calls or puts, the dynamics are the same. You enter into an agreement where you either take some action in the future or let the contracts expire. If your options expire, you lose the entire premium that you paid for the contracts.
Call options are the right to buy a standardized number of shares (usually 100) on or before a date determined at the time of the agreement. The price that you’ll pay for the shares (should you decide to exercise your right) is also predetermined.
Put options are similar, as you agree on the price and the date, but instead of buying shares, you are selling them. This is what confuses most beginners of options trading.
Instead of looking at puts as selling something you don’t own, think of it as buying shares at a lower price and having the right to sell them to the option writer at a higher price.
That is essentially what most put buyers would do if they chose to exercise their put options.
Illustrating the concept
Suppose an investor believes that the shares of XYZ, trading at $50 per share, are overvalued. The investor believes the price is due for a drop and decides to purchase a put option with an expiration of three months from the current date.
Assume the investor purchased the put options at $3.00. The total cost is $300 ($3 premium x 100 shares). No commissions are considered for this example. The strike price for this contract is $50.
After three months, the investor turns out to be correct, and the stock drops to $25. At that point, she decides to exercise her option.
She buys 100 shares of XYZ at the current price of $25. Since her put contract has a strike price of $50, she calls her broker to exercise her option, selling the newly-bought shares to the put writer at $50 per share. The investor made a quick $2,200. (Bought for $25 and sold for $50, less the premium paid, multiplied by 100).
As you can see in the example, there was never a point where the investor sold stock she didn’t own. She took ownership of 100 shares of XYZ at the lower (and current) market price. She immediately sold those shares at the agreed-upon option strike price.
This concept takes a bit of time for investors to grasp. It’s crucial to get this, though. Without this understanding, investors may implement the wrong strategies, which could lead to losses.
Put buying is a defensive strategy. Investors believe the underlying stocks are going to drop.
When you understand the dynamics of puts, you can use them to protect your investments. Some investors, for instance, buy shares of a stock and then buy a corresponding put to limit any declines the shares experience. This is the basic idea of some hedging strategies.
This concept makes sense in theory, but it is challenging to implement correctly. The biggest issue is knowing when to close out the put contract (or exercise it).
How far should investors wait before they take the protection offered by the put? That is never an easy question to answer.