What Are Stock Put Options?

Stock put options are a form of traded option contract investors use to leverage stock transactions or to protect (hedge) against downside risk. A stock put option confers the right to sell shares of a particular stock (the underlying security) at a specified price called the strike price, although the option buyer is not required to do so. The option contract may be exercised up until its expiration date (called the expiry). Stock put options are traded on exchanges like the Chicago Board of Options Exchange (CBOE), the American Stock Exchange (AMEX), and over-the-counter (OTC).

Identification

Stock options come in many flavors. The basic option contract gives the buyer the right to purchase (call options) or sell (put options) shares of stock. On exchanges like the CBOE a standardized contract for 100 shares is used. OTC stock options are sometimes non-standard contracts (called exotic options). A put or call option contract may be issued for as little as three months, or for several years. Investors buy call options when they think a stock's price will rise. However, if the investor thinks a stock may drop in price, he/she can buy a put option instead.

Buying Puts

When you buy a stock put option, you have the right to sell shares to the writer (issuer) of the option contract. The writer charges a premium (usually under $1/share). If the stock falls far enough below the strike price before its expiry to cover the writer's premium, you can buy the stock at the lower price and then sell it at the strike price. This is called being "in the money." For example, suppose you buy a stock put option with a strike price of $20/share. You pay the writer a $1/share premium for the put option. If the stock falls to $17 before expiry, you purchase the shares for $17/share, sell them to the writer for $20/share, and keep $3/share. Your profit is $2/share ($3 minus the $1 premium).

Writing Puts

The writers of stock put options takes on the downside risk (the chance the underlying stock may rise in price) in exchange for the premiums they charge. If a stock stays above the strike price, the option won't be exercised and the writer keeps the premium. If the stock declines and the buyer exercises the option, the writer must buy the stock at the strike price. The writer then must choose whether to hold the stock in hopes the price will recover or sell it and take the loss.

Hedging

Many investors use stock put options to hedge positions in a stock. Let's say you bought a stock at $20 per share and it has risen to $30 per share. You may think the stock will go even higher, or you may wish to hold the stock long enough to qualify for capital gains tax rates. But you don't want to risk losing the profit you already made. You can buy a stock put option with a strike price of $30 per share. Your expense is the premium, but beyond that, you are now protected against a possible drop in the price of the stock.

Risk

Hedging is a conservative trading strategy aimed at reducing risk. Option trading alone is a high risk form of investing. The potential profits are high. For instance, in the example above (see Buying Puts) you would have instead $100 for a contract and made $200 profit---a 200 percent gain. The risk aspect of put options is simple. If the price of the stock does not fall below the strike price before the expiry, you lose 100 percent of your investment.