What is a put option? Understanding how to trade them

• Put options are contracts that allow investors to sell a specific number of securities at a predetermined price within a specified timeframe.
• They are bought when a trader expects the option's underlying asset to fall.
• In most cases, brokerage firms require that investors apply and be approved to buy options.

Attempting to predict the next stock market crash feels like an annual Wall Street tradition. In 2016, some predicted that there could be a 50% drop in the market. In 2017, legendary investor Jim Roger's predicted that we would see the "worst crash in our lifetime."

Neither of those predictions turnout out to be nearly as bleak. While we did experience a recession in 2020 because of the coronavirus pandemic, we now know that it was the shortest recession on record, lasting only two months, according to data from the National Bureau of Economic Research. We also know that the S&P 500 is up more than 100% since January 2016.

Despite that, it doesn't mean that these economic setbacks are any less painful. Most investors are aware that the stock market does go through phases of expansion and contraction. But what if there was a way to make money even when the market falls? This is where put options become a useful financial tool.

What is a put option?

A put option is a contract that allows the owner the right (but not the obligation) to sell an asset at a predetermined price, known as the strike price. Those who buy put option contracts are essentially betting that the asset's price will fall. The further that the underlying asset's price falls, the more valuable the option contract can become.

"In short, option contracts allow you to profit from renting stock without actually owning the shares," said Cassandra Cummings, a registered investment advisor and founder of the Stocks & Stilettos Society.

How do put options work?

Each put option contract represents 100 shares of the underlying asset, but investors don't need to own the stock to buy or sell a put.

When an option is purchased, the buyer pays what's called a premium. The premium is the maximum amount that the option buyer can lose in a trade. This is because options have an expiration date. If the put is not traded or exercised by the expiration date the contract will become worthless. Put options are available for stocks, ETFs, silver and more.

Put options become more valuable as the underlying stock's price falls and loses value when the stock's price rises. Generally the value of a put option can also decrease as it approaches the expiration date. This is known as time decay, to minimize this Cummings suggests purchasing contracts that go out at least 45-60 days.

The process of determining the profitability of an option is found using intrinsic value. Intrinsic value is calculated for a put option by subtracting the strike price by the price of the underlying asset. For our example, the strike price was $100 and the current price is$80. This makes the intrinsic value $20.

Quick tip: The formula to determine the intrinsic value of an option does not take into account profit, which is calculated by subtracting the cost of the premium.

Example of a put option

After doing some research let's say that you have concluded that shares of ABC company will fall below $100 per share which is where our fictional company is currently trading. By purchasing a put option for $5, you now have the right to sell 100 shares at $100 per share.

If the ABC company's stock drops to $80 then you could exercise the option and sell 100 shares at $100 per share resulting in a total profit of $1,500. Broken out, that is the $20 profit minus the $5 premium paid for the option, multiplied by 100 shares.

If you do not own 100 shares of the stock, you could choose to sell the option contract to another buyer, this practice is known more simply as options trading.

Quick tip: Options are one category of financial derivatives, this is because their value is determined in part by the value of the underlying asset.

If the company is trading below the strike price (in our example the strike price was $100) then the option is trading "in the money" (ITM), this is because the option holder would see a profit if the option was exercised. Out of the money (OTM) is the opposite meaning that the current price of the stock is above the strike price. In our example, any price above $100 would mean the option is currently out of the money. Finally, you have a put option that can be "at the money" (ATM) meaning the stock's current price is very close to or equal to the strike price.

Put option vs. call option

Think of put options and call options as two sides of the same coin with their respective characteristics essentially inverted. If an investor feels a stock will rise, they may purchase a call option. If they feel the price will fall they may choose a put option. One common refrain to help you remember this is "call up and put down."

How to buy put options

Put options are a bit more complex than simply buying and selling stocks or index funds. In most cases, brokerage firms require that investors apply and be approved to buy options. Depending on the brokerage firm, you'll need to complete a questionnaire to gauge your experience and risk tolerance.

You may also be asked to provide your annual income and net worth. Generally, within a few business days your account will be approved (or denied) for certain levels of option trading strategies. If the account is approved, you can buy put options in your account - just keep in mind that certain put option trading techniques are not allowed within IRAs. Option trading levels range from Level 1 to Level 5, with Level 5 being the most complex.

Quick tip: Remember that buying a put option is different from selling a put option. Selling a put means that you will receive the premium as income but you may also incur the risk of being forced to buy the shares of the underlying stock if the price falls below the strike price.

The financial takeaway

Put options can be a good way to protect against downside risk if the market falls but they also come with added risks and complexity. Unlike trading a stock, trading a put option requires the investor to be right on three levels: the underlying asset, the direction and the timing since all options contracts have an expiration date.

"Risk management is also important," says Cummings, "Many new investors avoid risk management techniques such as entering trailing stop loss orders to lock-in profit on the upside and protect their premium on the downside."