Put options are a contract between a buyer, known as the holder, and a seller, known as the writer.
An investor can profit from both buying and selling put options, but there is risk involved. This article should provide investors with the understanding needed to manage that risk and profit from buying and selling put options.
Put options give the holder the right to sell shares of an underlying security at a fixed price, known as the strike price, by an expiration date. The holder of the put option pays the writer of that put option a premium for the right.
If the holder exercises his right and sells the shares of the underlying security, then the writer of the put option is obligated to buy the shares from him. If the holder does not exercise his right before the expiration date, then the option expires and has no value.
Let’s look at a couple examples to see how an investor can profit from either buying or selling a put option.
Put Option Examples:
- Buying a put option: Assume Disney (NYSE: DIS) has a price per share of $102. A put option holder buys the option for DIS with a strike price of $100 that expires in one month. The put option holder then can profit if the market value of the stock falls in the next month. As the holder of the put option, he now has the right to sell 100 shares of DIS at a price of $100 until the expiration date. Keep in mind one put option is equal to 100 shares of a company’s stock. Let’s assume the premium for the put option costs $3 per share and the buyer pays $300 for the DIS put option. Assume the share price of DIS drops to $95. The buyer can exercise the put option and buy 100 shares of stock at $95 and have the right to sell it for $100. The option writer is obligated to buy the shares from the buyer at the price of $100 even though the market price is $95. The option buyer will make a profit of $5 per share from the option ($100 – $95). After accounting for the premium paid, the buyer walks away with a profit of $2 per share ($5 – $3).
- Selling a put option: Assume a put option writer owns 100 shares of DIS stock at a market price of $102. The put option writer/seller then can profit if the share price of DIS does not fall below $102 over the next three weeks. Suppose the put option writer decides to sell a put option with a strike price of $100 that expires in three weeks. The put option seller then collects a premium of $2 per share by writing this option for DIS. Assume DIS closes above $100 for the next three weeks. The put option expires and becomes worthless. The option seller retains the $200 premium and keeps the 100 shares that he owns. If DIS falls below $100 before expiration, then the option could be exercised, and the seller is obligated to give up the 100 shares.
These basic examples of buying and selling put options highlight the major differences between the two different strategies, and show how an investor can profit, or lose, from both buying and selling put options.