What are Put Options?
Put Options: You buy put options when you believe the stock will go down. A put option is a contract that locks in a selling price of a stock for you until a given date. Generally, a put option is a contract that allows you to shares 100 shares of a stock.
Trading options is like stock picking on steroids. Let’s understand how a put option works, with the help of an example.
How To Trade Put Options?
READ THIS BEFORE YOU PUT ANY MONEY INTO PUT OPTIONS.
- Expiration date: The date on which the contract expires, Sep 16, 2022 in this case.
- Share Price: This is the share price of the stock in real time (the current market price)
- The Strike Price: This is price i.e. $370 at which you can sell 100 shares of AAPL stock anytime before the expiration date, according to the ‘option’ contract.
- Premium: This is the amount of money ($70 x 100 = $7,000) you’d pay to buy this put ‘option’ contract to lock in a share selling price @ $370.
Let’s focus on the highlighted put option. We are looking at AAPL (Apple) stock put options. Why put option? Because we believe the AAPL stock will fall in price over the next two years. We have chosen an expiration date of Sep 16, 2022 and want to bet on Apple’s share price going down.
The contract we are looking at is the $370 put option, which means this contract will lock in a selling price of $370 per Apple share * 100 shares, until Sept 16, 2022 no matter how low Apple’s share price go. For buying this contract, we need to pay a premium – just consider it the cost of the contract – $70 per share * 100 shares. So this contract would cost us $7,000.
Let’s say we believe that the Apple stock is overvalued and anticipate it to fall. So, we want to buy the contract for $7,000 today. Since there’s no guarantee of price rise of price fall in stock market, we will evaluate a few scenarios to see how much money we can make or lose, depending on how the AAPL stock performs between today and the expiration day of the contract, Sep 16, 2022.
CASE 1: AAPL stock falls and hits a rock bottom price of $100 before Sept 16, 2022
The market crashes, Apple’s share price tanks, and AAPL hits a low of $100 per share. So, how much do we benefit in this case?
Let’s compute our costs and market value of the contract.
If we want to use the contract to actually sell 100 shares, we can do that. According to the contract we can sell 100 shares @ $370 each, so we can buy 100 shares directly from the market at $100 each, i.e. for a total of $10,000 and sell them for $370 each, i.e. $37,000 in total.
Total cost of 100 shares and ‘put option’ contract = $10,000 + $7,000 = $17,000
Selling Value of 100 AAPL shares according to the ‘put option’ contract = $370 * 100 = $37,000
Profit = $37,000 – $17,000 = $20,000
We can go through the process of actually buying the 100 shares and selling the 100 shares, or we can just the sell the contract to someone else without going through the hassle of buying and selling 100 shares.
What is the value of contract in case we want to sell it now?
The contract is promising a locked-in selling price of AAPL at $370, and the current market price of AAPL share is $100. So technically the contract is worth $270 now. You can sell the contract for a price around $270 * 100 = $27,000.
The actual price will vary depending on when you’re selling the contract how many days are left before the contract expires (say in Jan 2022 AAPL reaches $100, and you’re selling the contract in Jan 2022 itself, almost 9 months before contract expires), because the AAPL stock might have more room to fall before the contract expires. In that case, you can fetch a higher price than $27,000 also.
Profit made: $20,000 or 186%
CASE 2: AAPL stock reaches a low of $320 before Sept 16, 2022
Let’s assume the markets fell a bit, but AAPL stock didn’t really crash. The stock price went down to $320 and that’s the lowest price before Sept 16, 2022.
What happens now?
We can use the contract to sell 100 shares @ $370 each, valuing the sale at $37,000. We can buy the 100 shares from market at $320 each for a total of $32,000. Initially we had paid $7,000 for the ‘put option’ contract. So our total cost would be $32,000 + $7,000 = $39,000.
At the locked in selling price of $370 each, we can get $37,000 by selling the 100 shares.
So, our costs ($39,000) are higher than the contract price value of 100 shares ($37,000). We now have a problem. We made a loss. How much?
$37,000 – $39,000 = -$2,000
We can buy and sell 100 shares, or we can simply sell the contract to someone else. Technically the price of the contract should now be about $370 – $320 = $50. We can expect to sell it at $50 * 100 = $5000.
Again, as in case 1, the price you’ll fetch by selling the contract could vary, but $5000 is a fair estimate.
Loss incurred: $2,000 or 28.6%
CASE 3: AAPL stock rises and goes up to $400 and doesn’t fall from there before Sept 16, 2022
We know that markets can be unpredictable. In the middle of pandemic and economic contraction, the shares just keep rising! The stock keeps rising and goes to hit $400 before the expiration date, Sept 16, 2022.
What is the value of our contract now?
Thinking logically, why would anyone want to buy a contract to sell 100 AAPL shares @ $370 each when they can directly sell AAPL shares at $400 each in the market?
This is where the contract becomes worthless.
Put Options can also be used as part of loss limiting strategy
Continuing our example in case 3, if we want to use the contract to sell 100 shares, total cost = $40,000 + $7,000 = $47,000. The selling value 100 shares according to ‘put option’ contract = $37,000
Loss incurred: $37,000 – $47,000 = -$10,000
This is where put options are helpful. They can limit your losses. Since we had bought the contract that gave us an option to sell 100 shares. We DO NOT necessarily have to sell the 100 shares. We will let the contract expire. In this case we will lose all the value, i.e. $7,000 we initially paid, but we will not have to incur any further loss, no matter whether AAPL stock goes up to $400, $500, or goes berserk and hits $1,000.
While put options, much like call options, can bring great returns, or steep losses, the good thing about options is that they limit your losses to the purchase price of the contract, i.e. $7,000 in our example.
Conclusion on Put Options
Put options can be insanely rewarding, they can be excellent for limiting losses, BUT they can very quickly wipe out value too. Options are not for the faint hearted, and definitely NOT for someone who doesn’t fully understand how options work.
If you know what you are doing, put options can be a great addition to your portfolio.
- If the stock price goes below the breakeven price ( strike price – cost of contract i.e. $370 – $70 = $300), put options can bring accelerated returns to the investor.
- In case the stock price stays above the breakeven price ($300), the investor incurs accelerated losses.
- If the stock price rise above the strike price i.e. $370 (and stays above that until the expiration date), the investor loses all the money spent on the contract.
- The investor’s loss is limited to money spent on the put option, no matter how high the stock price rises further. A stock price jump from $370 to $1000 would not cause any additional loss to the ‘put option’ investor.
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