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Put options are a tremendous tool in the options trading world. This basic options building block offers the options strategist a variety of advantages. For example, buying a put option is a great alternative to short selling stock because even though both strategies allow traders the opportunity to make a profit from a declining equity price, only put buying does so with limited risk. This is just one of the advantages that put options offer. First however it is important to understand what a put option really entails.

A put option gives the buyer the right, but not the obligation, to sell 100 shares of the underlying stock at a fixed price until the option’s expiration date. Put options are offered in various strike prices with a variety of expiration dates. A straight put option is purchased when the strategist anticipates a fall in the price of the underlying asset. The maximum risk in this position is the price paid for the put option premium and the maximum profit is limited as the stock price falls below the breakeven to zero. The breakeven point is calculated by subtracting the put option premium from the put strike price.    

The time value of a put option decays as the time to expiration gets closer, whereas the intrinsic value does not erode provided the stock price remains the same. For a put option, the stock price must be lower than the strike price of the option to have any intrinsic value. There are three key relationships the option strategist must understand when it comes to put option values. First, if the option strike price is less than the stock price, the put option is considered out-of-the-money and contains only time value. Second, if the option strike price equals the stock price then the put option is considered at-the-money and contains only time value. Finally, if the option strike price is greater than the stock price the put option is considered in-the-money and possesses both time value and intrinsic value.

To illustrate how purchasing a put option actually works lets walkthrough an example using the stock eBay (EBAY). Assume Trader X is bearish on eBay and buys an April 2005 put for a premium of 7.2. In Figure 1.1 you can see the related trade parameters and risk profile for this particular long put position, courtesy of the Optionetics Platinum options analysis tool. As is depicted in the risk graph, the maximum risk is the $720 debit while the maximum profit is $10,779.90 if eBay were to go to zero by the expiration date. The breakeven point is 107.80 and below this price the trade starts to become profitable. Risk graphs are excellent tools to visually depict these parameters.

Once eBay starts to move lower, the option strategist can capture a profit in one or two ways by either exercising the put option or offsetting it to close the position. If the put is exercised, the options strategist will become short 100 shares of eBay. If and when eBay falls below the put strike price, the strategist can exercise the put to short the shares at a higher price and then buy eBay at a cheaper price to cover the short and exit the trade.  The profit would be the strike price minus the current price.

The second method for profiting on a put comes from offsetting it. If the price of eBay falls, the corresponding put premium increases and the put can then be offset at a profit by selling a put with the same strike and expiration.

Puts are versatile tools that can regularly and profitably be employed by the options strategist. When buying a straight put option you definitely want to possess a bearish bias on the underlying asset as well as making sure the put option is trading at low implied volatility levels. Implied volatility is a measure of an underlying asset’s volatility as reflected in an option’s price. It is the volatility implied by the option’s current price. For put options the strategist wants to be sure to purchase put options only when implied volatility is at low levels.

As you get more comfortable with the put option you will see that they have a variety of other uses. For instance, they are great tools to protect profits accumulated on an underlying stock as well as being combined with calls and stock together to create a virtually risk free position with tremendous adjustment capabilities. The trader should make a concerted effort to understand this basic options building block called the put. Believe me, it is well worth the time to do so.

Figure 1.1: Risk Graph of EBAY April 115 Put (Source: Optionetics Platinum)

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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