Put options give you the right to sell a specific stock at a specific price sometime in the future. For this right, you pay the seller a fee which is determined by market forces. There are generally two reasons you would want to buy a put. If you owned the stock and feel it still has potential to appreciate you may want to ensure that you can partially protect your paper profit by purchasing a put. On the other hand, if you do not want to short a stock, but feel it is entering a bearish period you could purchase a put to participate in the perceived downturn.
One option controls 100 shares of stock. Therefore, when you look in a newspaper or on the internet for a stock option quote you may see Dec 40 $2.50. What this means is that for $250 you can buy the right to sell 100 shares of stock for $40 up to the close of trading on the 3rd Friday of December. No matter what month you purchase, options always expire on the 3rd Friday of the month.
Traders who sell puts are looking for a decrease in the stock price and want to use the leverage of the option to increase their return.
The cost of an option is mainly dependent on two factors – distance to the strike price and time to expiration. In the above example if you are purchasing a December option in the middle of October then you are receiving approximately two months worth of time value.
If you purchased a January option with the same strike price it should cost more. If the stock is selling at $39 you are also receiving $1 (40 – 39) of intrinsic value. If the stock was selling at $41 the put option would cost less as the option would contain no intrinsic value.
After you purchase the put but before expiration, you can either resell the option or if you own the stock, you can sell it to the put seller for $40 per share provided the share price is below $40.
After the option has expired one of two things will happen. If the stock is above $40 the put option will expire worthless and you will have lost the money you used to purchase the option. On the other hand if the stock is below $40 your broker would generally sell your stock to the put seller and deposit $40 per share minus applicable commissions into your account.
There is another opportunity that you may want to consider trading puts. In this situation, you sell the put option on a stock which you think is going to go up or sideways for a while. In this case, you need to be happy with purchasing the stock at the strike price of the put.
As an example, on November 20, 2006 you may be interested in buying Intel (INTC) at 22.25 but are concerned about the recent volatility. Instead of buying the stock, you decide to sell the April 22.50 put for 1.40 per share. What you have done is pocket $140 per put contract and if INTC is above 22.50 on the 3rd Friday of April 2007 you do nothing else. If however, INTC is below 22.50, you would then buy it for the equivalent of $21.10 (22.50 – 1.40).
In this scenario, you generally want the stock to advance away from the strike price such that you can use the cash or margin in your account to initiate another transaction.
If you are still looking for more information on puts, you may want to investigate other information on put options.