What is a Put Option? Should you buy it?
For every investor who bets their money on the stock market, the skyrocketing share price is the last thing they want. When they invest in stocks, the only chance for higher returns is the consistent increase in the share price. In other words, the dropping share price is equal to losing money.
However, for experienced investors, taking advantage of stock options will guarantee they are bound to earn money, even if the share price goes downwards. Sounds counter-intuitive? That is exactly why we would like to walk you through the "put option", which is the silver bullet when you are trapped in a bear market.
What Is a Put Option?
According to academic definition, a put option is a contract in financial markets that gives the purchaser of the put option the right to sell an underlying asset at a pre-agreed price at a specified date. This long definition may be hard to comprehend. If you want to see a shorter definition, you can just remember the put option resembles the insurance policy. In simple terms, the put option allows you to earn profits as the price of the underlying asset (i.e. stocks) falls.
To give you a clearer understanding of the put options, let's dive deeper into the basics.
The seller sets the duration of the put option. This means a put option will be settled at the expiration date, unlike stocks which can exist indefinitely so long as the listed companies are not delisted. Then, the buyer pays the seller the predetermined fees as the premiums, or the cost for the buyer to purchase this contract.
Everyone wishes the share price could rise without an end, but sometimes negative news always happens, leading to declines in share prices. That is why we need to protect our returns on stocks by purchasing the put options, just like we would buy a life insurance policy to ensure we can still receive some returns when terrible events happen to us.
How a Put Option Works
As we mentioned above, the value of the put option increases as the price of the underlying stock declines. Therefore, the put options are frequently used to speculate on the downward price movement, namely, for hedging purposes.
When you purchase a put option, you are betting that the price of the underlying stock will go down before the expiration date. If the price really moves in your favor later, then you can choose to sell the underlying stock at the pre-established price level (higher than the current decreased price) by exercising the put option. By contrast, the seller of the put option is betting the share price will stay around the pre-established price (strike price) or go above it, so that the seller could earn the income through his or her bullish bet on the share price.
For the American-style options, you are allowed to exercise the option at any time before the expiration date. But for the European-style options, you are only allowed to exercise the option at the expiration date. As you can see, the American-style options could offer investors more flexibility. Thus, they also command higher premiums than the European-style equivalents. Right now, all the stock options in Hong Kong Exchanges and Clearing (HKEX) are American-style.
In a word, the put options will help the buyer earn money when the share price is lower than the pre-established price, or help the seller earn money when the share price stays flat or goes upward.
If the above description is still hard to comprehend. Don't worry. Let's break it down with more examples.
Imagine a listed company named ABC is trading for $30 per share. The put option with a strike price of $30 for this stock is sold with $3 premium per share, expiring in three months. In this case, the total cost will be $300 per lot ($30 premium x 100 shares).
Example of buying the put option
Clearly, the break-even point for the buyer is $30 for the share price, excluding the premium. If the share price declines to $10, then the buyer of the put option can still sell the stocks at $30 per share by exercising the put option. In other words, the total profit for the buyer will be $1,700 (($30-$10) x 100 shares - $300 total cost).
On the other hand, if the share price rises to $50, this means the buyer will probably not exercise the put option with the strike price of $30. Therefore, the loss for the buyer will just be a $300 premium.
Example of selling the put option
For the seller of the put option, the break-even point is also $30 for the share price, excluding the premium. If the share price rises above $30, then the seller will earn the profit of $300 premium paid by the buyer. However, no matter the share price rises to $30, $50, or even $100, the profit for the seller remains the $300 premium, as the market price is above the strike price. Thus, selling the stocks at the strike price of $30 does not make any sense now.
On the other hand, if the share price declines to $10, the seller would suffer heavy losses ($2,700), because the market price is far lower than the exercise price ($30 strike price paid x 100 shares - $300 premium).
When should I put options? (Why should I put options?)
The put options are excellent tools for investors to hedge their risks under a bearish market. More specifically, the benefits of purchasing the put options may include:
Offset the market risks
As we can see from the above examples, the put option just functions as the health insurance policy for our common people. If you expect the share price of a listed company will go downwards soon, then purchasing a put option of this stock will help you offset the potential risk of the falling share price. Even if the share price moves in the direction opposite to your expectation, you just lose some premiums. In short, just paying some premiums will help you easily hedge the market risks. In addition, based on the above examples, the maximized profits for the buyer of a put option could be $1,700, while the maximized profits for the seller of puts are just the $300 premium itself. This shows the put option may bring more benefits to the buyer than the seller.
Earn income from the premium
The put option can not only give the buyer of the put option a kind of insurance policy, but also help the seller earn income. Although the income from selling the put option is not a huge amount of money compared with the potential returns from purchasing the put option, the income is still attractive under a bullish market environment.
How to buy and sell put options
Just like many other types of investment tools, you can trade put options through brokerages. The features, such as commissions, investment choices, and coverage, often vary between various brokers. Thus, we highly recommend that you should do your homework first by checking the pros and cons of different brokers that specialize in trading options. This would help you identify the broker that is best suited to your investment demands.
Frequently Asked Questions (FAQ)
What is a put option?
- A put option is a contract in financial markets that gives the purchaser of the put option the right to sell an underlying asset at a pre-agreed price at a specified date. The put option just serves as the insurance policy for common people.
How does a put option work?
- The put options are frequently used to speculate on the downward price movement, namely, for hedging purposes. The put options will help the buyer earn money when the share price is lower than the pre-established price, or help the seller earn money when the share price stays flat or goes upward.
How to trade put options?
- Put options are often traded through brokerages. The features, such as commissions, investment choices, and coverage, often vary between various brokers. You are highly recommended to check the pros and cons of various brokers that specialize in trading options.