Following up from the “what is a call option” article we turn to what is a put option. This one should be even shorter, because if you have read the “what is an option” and the bit on calls you should have a thorough understanding of options at their basic level. One thing that I will include here is a longer bit on using puts as hedges against your positions, and I will explain why I go into more detail in that section.
I seriously recommend that you not approach this article without understanding the prior articles. If you already have a basic understanding of options and calls, then you probably already know what a put is. It seems odd that you would be so complete in your knowledge and yet miss only this one key piece.
Future ideas for articles in this vein will be explaining option premiums and pricing, which is a more advanced topic but no less important to understanding options. Also, I will go over options writing, and also the type of orders involved in options trades Outside of the options series will be topics ranging from mutual funds, ETFs, forex, and beyond. These are all introductions. For those of you with a strong grip on the basics I will discuss strategies and theory beyond these simple definitions.
Description of the Put Option Contract
Party A gives party B the right to sell shares of a stock at a certain price to party A. This is the reverse of a call option. In this case B will be selling the shares and A is forced to buy them. In a call option B will be buying the shares and A is forced to sell them. Understanding this distinction is important. They might seem like opposites but it is not useful to think of them like that. The relationship between calls and puts is not the same relationship as being long or short a stock. As I will discuss in a later article it is possible to be short calls and puts.
With puts the transaction embodied in the options contract will be for a value higher than the market price. As you recall with calls the transaction will take place at a value lower than the market price. So if you have a put with a strike of $10 then you would exercise it when the price of the underlying stock was below $10.
The same rules as calls obviously apply. Your brokerage will automatically exercise your in-the-money put options at expiry and if you cannot afford to cover the transaction you should just sell the puts, hopefully for a gain.
In-the-money Puts Quickly
By now you should have a strong grasp of the concept around “the-money” in its various forms. For puts if the underlying stock is less than the strike on the option then it is in the money. So if the strike is $10 then less than $10 is in-the-money. Around $10 is at-the-money, which is a term of convenience. Above $10 is out-of-the-money.
Role of Puts
Without citing my source like some pretend scholarly schmuck, I maintain that the majority of market participants are long stocks. I should define what long and short means in another article. I know its basic, but that is why this is the beginner series.
The reason that I am going over the role of puts again when I did not for calls is because puts are probably more important for hedging for the vast majority of people. You can buy puts to protect your investment from drastic moves downward. For example, you could get some puts prior to earnings in case there is a big miss and the stock’s value is cut in half. If you have gains from the last few years you could protect those gains. A quick example will do you wonders.
In 2010 you bought 500 shares of Y when Y was at $10. Now in 2014 the stock is at $30 thanks to the great bull market. Now earnings have become a bit less obvious as expectations have risen, but the company might not be able to secure a beat this time. You could grab 5 put contracts at the $25 level, though this might be a bit expensive around earnings time. Still you could buy it a few months out which would make it more expensive, but you would not be paying for the implied volatility and you could probably resell the put afterwards to recover some money.
The concept of implied volatility and time value is a new one, and that article will be coming soon. You might have to come back to this section after you read that article. I apologize but the interconnectivity of knowledge is not my fault. Back to the example.
You would be protecting your investment if the stock dips below $25. The put option would have value itself, but you could also sell off your position via the put for the price of $25. That way you would be out of the stock that might not be a wise investment anymore. And $25 is still far above the $10 that you bought it for. If the stock does decline your puts might be worth it, however if the stock continues to do well then the puts will decline in value. They might even end up being effectively worthless. That is the price of protection. As stated above if you buy them a bit further out in time they might retain some more of their value and you can get some cash back if you sell.
I do not really use options to hedge my positions so I am not aware of the ins and outs. I can however speculate a bit, but without the piece on time value it might fall on deaf ears. The thing is that if you have a lot of time on your options they have value aside from the disparity between the strike and the market value. So it would seem to me that once the options are ITM you could sell them and sell your stock and come out better off than if you just exercised or waited till expiry. You might have to confirm this on your own since I do not hedge, I do not know.
There have been a lot of stocks I have seen that drop drastically on earnings. Some dropped as much as 50% and I have often seen 30% drops. It is not a bad idea to give yourself some downside protection if you are worried. Though I would just take some profits and lessen my exposure. Strategies can be discussed later, but at least now you see the role of puts outside of just being another form of investment.
I have hinted at a lot of advanced concepts here with premium and time value. That will be the next article in this series and hopefully a direct discussion will help you understand the points in this post better. Options are not easy, but this is the beginner information for options. You should really have a strong grasp of investing in regular stocks before moving up to options. Now we can leave put options behind and move onto more difficult topics.