Definition: A put option represents a contractual agreement between a buyer (holder) and seller (writer). The buyer of the put has the right to sell an underlying asset at a specified price (strike price) and quantity for a fixed period of time (expiration).
The seller of the put has the obligation to buy the underlying asset at the specified price and quantity, if the option can be exercised before the expiration date. By taking on the obligation and risk of delivering the underlying asset to the call holder, the seller is paid a premium.
For stock options, each put option covers 100 shares.
Buying Put Options
Traders buy put options when they are bearish on a stock (long puts). Let’s take a look at an example to help you understand the basic concept of buying a put option.
Stock ABC is trading at $25. You purchase a put option with two months to expire with a strike price of $25 for $1 ($100 because each option covers 100 shares). Two months go buy and the stock is trading at $22. Since you have the right to exercise your option, you are able to sell 100 shares of the stock at $25 and buy it at the current price of $22. This trade results in a profit of $200 ($300 for price difference - $100 option premium).
If the stock goes up to $29 over those two months, the buyer of the option losses out on the $100 spent to acquire the put option.
Selling Put Options
Traders can take the opposite side of the trade and sell (write) the put option. In this case, the trader hopes that the option expires worthless by the expiration date and they profit from selling the premium. A trader can sell covered puts or naked puts.
Selling covered puts, means the trader is short the underlying stock that the puts are being sold against. For example someone is short 100 shares of stock ABC. A covered put strategy involves selling puts against those shares in hopes of generating money from the premium collected. Please see our educational webpage about covered calls to get more details.
Naked (uncovered) Puts
In the case of selling puts uncovered, the trader doesn’t have a short position on the underlying stock. This strategy is bullish and a way to purchase stocks at a discounted price. Please see our educational webpage about naked puts to get more details.
Put spread strategies involves selling two puts simultaneously with different strike prices and/or expiration dates. Spreads limit the amount of money a trader can lose on any specific trade, but also limits the potential profit at the same time. Please check out the different put spread strategies throughout our website.