Saturday, October 6, 2007

Put Option - Stock Put Options

What are Put Options?

A Put is a contract on a particular stock, index or other security that allows the investor to sell the underlying stock at a set price (strike price).

The holder of his option has paid a premium (cost of the contract) to buy it. Put options are profitable when the market is in decline. If the investor has a put on a stock that has now fallen enough to cover the cost of the premium, the person would be profitable.

Ways to Profit with Put Options

Trading them:

If the Put is profitable, the investor can sell or trade the contract back to the market. The profit on the contract is shown by the premium increase on the option. As the market declines, the premium increases. This premium increase allows the investor to sell the contract. He is not "exercising the option". He is trading it out. This is how most options are done vs. exercising.

Exercising them:

When an investor exercises a Put Option, he or she is selling a stock they already own. The right of a put holder is the right to sell the stock at the strike price, regardless of the actual price in the market. If you owned a Put with a strike price of 50, and the market has declined to 40, you could purchase the actual the stock in the market at 40 and then exercise the put at 50. You would make 10 points on that stock, minus the premium paid.

The break-even for investors who own put options (disregarding commissions) is the strike price minus the premium paid. In the above example, if the investor paid $300 for the option - his break-even would be 47. Since the market in our example went down to 40, the actual profit for that person would be $700.

Writing a Put Option

When you sell or short a put option, you are "writing" the contract. The writer is someone who is bullish on the market. The seller collects the premium (as opposed to the buyer who pays the premium) and is hoping the option expires worthless. The premium is the writer's maximum gain. So, obviously if the premium is all that he can make - having the option expire is the best case scenario.

Put option writing does carry risk. If the option is exercised (by the holder/buyer), the writer must purchase the stock from the holder at the strike price. In the example above, the writer would have had to buy the stock at $50 (the current price), while the market was at $40. He would be stuck with a stock 10 points above the market. His loss would be lessened by the premium received. The writer can buy back the put before it is exercised, but if the put has gained value, the purchase price would be higher than the premium he originally got - so, it would be a loss either way. The option is expiring is the best bet.

Covered Put Option Writing

Since the seller or writer of puts must purchase the underlying stock at the strike price, he must have the cash to do that. Selling stock short and using the proceeds to cover an exercised option can be done. Also, the premium received for selling the put option can assist a short position to get greater profit.

As with any option, time is the biggest factor. Put options expire monthly. All options carry large risks, but can present large profits. Educate yourself further and talk to your broker.

Learn More: Put Options

Nick Hunter is the President of American Investment Training (AIT) and the owner of - A financial career and education website.