Most new investors find the idea of put options to be quite intimidating and do not know how to apply them to their investment strategies. They may either miss out on some potential profits or incur heavy losses without proper knowledge.
This guide aims to demystify put options, breaking down their mechanics, how they can be profitable, and the associated risks. Using real-life examples and simplified explanations, we will walk you through everything you need to know about put options.
You will understand, by the end of this article, what put options are, how they work, and how to apply them to achieve maximum returns, being aware of the risks that come with the process.
What is a Put Option?
A put option is a type of financial contract between buyer and seller. The buyer of the put option is purchasing the right, not the obligation, to sell a specified amount of an underlying asset at a pre-agreed price that is known as the strike price within a specified time frame. In return for providing this option, he receives a premium from the buyer.
Basics Understanding: An Example of Real Life
Let’s take the stock of Dave and Buster’s with the ticker symbol PLAY. Suppose, today, the stock is trading at $45 a share. As the seller, I give you a put option to sell me Dave and Buster’s stock for $40 per share within the month. For this right, you pay me a premium of $0.45 per share, which translates to $45 for 100 shares (since options normally trade in 100-share blocks).
How to Make Money from Put Options
You hope the stock price will drop down to below the strike price prior to the contract expiration. And, if the Dave and Buster’s falls to $30 per share, you can acquire it at the lower price then exercise your put option to sell to me at the $40-per-share price. Your profit per share will then become the difference of the strike price and the market price minus the premium paid. Here, you can earn $9.55 in a share, after subtracting the $0.45 premium you paid.
Risk of Put Option
On the other hand, if the stock does not fall below the strike price at $40 within the time allocated to the contract, your option is worthless. For instance, if the price of the stock falls to just $41 a share, you will feel no incentive to sell the stock at that price. Therefore, your loss will amount to the premium paid to acquire the option.
Duration of Contract: Time is Money
It greatly depends on the time to expiration for a put option’s price. The longer the time left, the more likely that the stock price may be in favor of the buyer and, therefore, the option becomes costlier. For instance, a one-month $40 put option costs $0.45, while a five-month option could cost $2.40. The longer the time, the better the chance for the stock price to fall and, thus, the higher premium.
Strike Price: The Price of Flexibility
The strike price is the other major factor that determines a put option value. The more room to maneuver and make a profit, the costlier the strike price. Therefore, a higher strike price may have a cost of $0.45 for $40, while the same $45 strike price would cost $1.90. A low strike price of $35 is relatively cheap because there is a small chance of achieving that particular price.
How to Buy a Put Option
1.To buy a put option, you’ll want to:
2.Find the stock symbol (example: PLAY for Dave and Buster’s).
3.Select an appropriate expiration date.
4.Choose the strike price.
5.Determine how many contracts to buy.
Each contract is equal to 100 shares. Take the $40 put option as an example. If you buy one contract at $0.45 per share, you’ll pay $45. If you wanted to buy 10 contracts, your total would be $450.
Selling the Put Option
In case the stock price plummets, you do not have to purchase the shares and sell them at the strike price. You can sell the put option itself at a profit. For example, if the stock drops to $30 per share, the value of your $40 put option increases, and you can sell it at a higher price than you paid, thereby locking in your gains.
Mastering Put Options
Problem Recap: The complexity of put options can be intimidating for beginners, leading to either missed opportunities or financial losses.
Platform Summary: Through this guide, we have broken down the mechanics of put options, using relatable examples and clear explanations to demystify the concept.
Now you can go out with confidence while dealing with put options. To make profits or reduce losses, knowledge about put options helps a person make rational decisions in the stock market. Always remember that although put options offer very profitable opportunities, it carries some kind of risk too. Therefore, one needs to do thorough research and proper planning to make best use of these options in their investment strategy
