Definition of Stock Market Puts
Stock market puts are somewhat esoteric, but their function is easily understood with a little study. Options are not as widely discussed as stocks. In stock market discussion, stock buying is given far more attention that stock shorting. It is no surprise then, that an option which gives someone the right to short a stock is not the most well-known investment instrument. However, investors who learn about puts give themselves an advantage by increasing their overall knowledge of the market.
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Shorting Stock
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Shorting shares of stock is the opposite of buying shares. In shorting, the investor technically borrows shares from a broker and sells them to someone else. The idea behind short selling is to profit from a decline in a stock's price. In short selling, the basic strategy of "buy low, sell high" still applies, only in this case the intent is to sell high before buying low. Just as an investor sells purchased shares to exit a position, the short seller buys back the shorted shares to exit the market.
Put Options
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Stock market put options, or simply "puts," are contracts giving the owner the right to short a stock at a certain price. This price is known as the strike price of the put and it indicates the price at which the put owner may short the underlying stock. While the put owner has the right to short, he is not obligated to enter the stock market. In fact, many option trading strategies deal only with buying and selling options rather than exercising the options to buy or short the underlying stock. Also, all put options have an expiration date after which they are no longer valid.
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Options and Shares
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Typically, one option represents 100 shares of stock. Therefore, if someone buys five puts on XYZ stock and each put has a strike price of $20, that person has the right to short 500 shares of XYZ at a market price of $20 per share. The investor in this scenario is forecasting that the price of XYZ will decline in the near future.
Put Option Value
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Put options increase in value when a stock's price falls. They decrease in value when a stock's price rises. This is due to the fact that puts give investors the right to short sell a stock. For example, assume an investor purchases five puts with strike prices of $20 each on XYZ stock and XYZ falls from $20 to $19. This investor is now in a favorable position because he can exercise his puts and sell XYZ at $20. After this, he can immediately buy XYZ back at the market price of $19 and realize a $1 profit per share, less the premium paid for the options.
Buying vs. Selling
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Options are traded just like stocks, with market supply and demand determining option prices. To buy a put option, the buyer pays the market price or premium to the put option seller. This gives the buyer the right, but not the obligation, to short the underlying stock while the seller assumes the obligation to buy the stock should the buyer exercise her right to sell. If the put option expires worthless, the option seller retains the premium received from the buyer.
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References
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