If you are interested in trading options, you may have heard of the term “buy a put option”. But what does it mean and how does it work? In this article, we will explain the basics of put options, how they can be used to profit from a falling market, and what are the risks and benefits involved.
What Is a Put Option?
A put option is a contract that gives the buyer the right, but not the obligation, to sell a certain amount of an underlying asset, such as a stock, at a predetermined price (called the strike price) within a specified time frame (called the expiration date). The seller of the put option, also known as the writer, has the obligation to buy the underlying asset from the buyer at the strike price if the buyer exercises the option.
The buyer of a put option pays a fee (called the premium) to the seller to acquire this right. The premium is determined by various factors, such as the current price of the underlying asset, the strike price, the time to expiration, the volatility of the underlying asset, and the interest rate.
Why Buy a Put Option?
The main reason to buy a put option is to profit from a decline in the price of the underlying asset. If the underlying asset falls below the strike price before or at expiration, the buyer can exercise the option and sell the asset at the strike price, which is higher than the current market price. The buyer can then buy back the asset at a lower price and pocket the difference, minus the premium paid for the option.
For example, suppose you buy a put option on XYZ stock with a strike price of $50 and an expiration date of one month. You pay $2 per share as premium, which means you pay $200 for one contract (each contract represents 100 shares). If XYZ stock drops to $40 before or at expiration, you can exercise your option and sell 100 shares of XYZ at $50 each. You can then buy back 100 shares of XYZ at $40 each and make a profit of $800 ($50 – $40 – $2) x 100.
Another reason to buy a put option is to hedge against downside risk in an existing position. If you own shares of an underlying asset and you are worried that its price may drop in the future, you can buy a put option to protect your investment. This strategy is known as a protective put. If the underlying asset falls below the strike price, you can exercise your option and sell your shares at the strike price, which limits your loss. If the underlying asset rises above the strike price, you can let your option expire worthless and keep your shares.
What Are the Risks and Benefits of Buying a Put Option?
Buying a put option has both advantages and disadvantages compared to short selling or other bearish strategies. Some of the benefits are:
You can profit from a falling market with limited risk. The maximum loss you can incur is equal to the premium paid for the option, regardless of how much
the underlying asset drops in price.
You can leverage your capital and control more shares with less money. For example, buying one put option on XYZ stock with a strike price of $50 and an expiration date of one month costs $200, while short selling 100 shares of XYZ stock at $50 costs $5,000.
You can benefit from an increase in volatility. Volatility is a measure of how much an asset’s price fluctuates over time. Higher volatility means higher uncertainty and higher risk, which makes options more expensive. If volatility increases after you buy a put option, its value will also increase.
Some of the drawbacks are:
You have to pay a premium upfront, which reduces your potential profit. The premium also decreases over time due to time decay , which means that
the value of your option erodes as it approaches expiration.
You have to be right about both the direction and timing of the market movement. If
the underlying asset does not fall below the strike price before or at expiration,
your option will expire worthless and you will lose your entire premium.