PUT OPTIONS

A put option is a contract between two parties which provides the buyer a right and the seller an obligation. The person who buys (goes long) the put has the right to force the seller to take possession of the underlying security at an agreed upon price. The person who sells (writes) the put obligates themselves to buy the underlying security at the agreed upon price. One option contract equals 100 shares of the underlying stock. An option consists of three characteristics:

1. Strike price – the price at which the buyer can take possession and the seller is obligated to deliver.
2. Premium – the amount of money paid by the buyer and collected by the seller
3. Expiration date – This is the date the option becomes worthless if the buyer isn’t in the money or doesn’t exercise his/her right.

An option incorporates a time value in the price. For example, let’s say XYZ is trading at 50 and the 50 put strike premium is 3$ with 4 weeks left before expiration. If XYZ doesn’t fluctuate, staying constant at 50, the price of the 50 put premium will gradually reduce from 3$ to zero as the 4 week time line decays ultimately ending with a value of zero on expiration day.

As you can imagine, given all the world, currency and commodity markets, there are almost unlimited investments most of which have some sort of tradeable option. There are American and European style options. American style options can be exercised at any point up to expiration whereas the European can only be exercised on the date of expiration. On many investable instruments options trade weekly, monthly, quarterly and yearly. Option expiration dates typically fall on a Friday with the most common expiration date being the third Friday of the month. There are exceptions however. For example, options on the S&p 500 volatility index (VIX) expire on the 3rd Wednesday of the month and quarterly options expire on the last day of the quarter.

Buying, or going long, a put is a way to protect oneself from a decline in value of the underlying security. Consider a put option as insurance in which you know the cost of the premium upfront and when the insurance expires. For example let’s say our XYZ is trading at 100 with earnings looming. You are concerned XYZ will drop in price so you buy a 100 strike put for 3$. We’ll say on expiration XYZ trades down to 90$ per share. Your 100 strike put entitles you to make the person on the other side buy (or you put to them) your stock at 100$ saving you a 7$ per share loss.

You can also use a put as a way to profit from the decline of the underlying security. Similar to a call, which makes money when a security increases in value, with the put you make money if the price drops before expiration of the option. The investor still has to be mindful of the time value of money. For example, let’s say the next month’s 100 put cost 0.50 on our XYZ which is trading at 101. We have 4 weeks to go before the 3rd Friday of the month which is the day the option expires. The time value of money causes a depreciation of the 0.50 each day that goes buy in which XYZ stays above 100 until ultimately the put is worth zero if XYZ closes at 100 or above on expiration day. In fact, the trade isn’t profitable unless XYZ declines in value enough to impact the 100 put or closes at 99.49 on expiration Friday.

Selling, or writing, a put allow/obligates (depends on if you are a glass is half full kind of person) you to buy the underlying security at an agreed upon price. Of the reasons an investor may write puts two include:

1 – Collect Premium

2 – Reduce Cost Basis

Collecting premium – An investor may write a put and use the premium as one tool to help increase overall account value or to generate cash which can be used as income. Think of it as the  complete opposite of a covered call. Instead of receiving a cash premium that obligates you to sell over an agreed upon price the cash premium received for the put obligates you to buy below an agreed upon price. If our XYZ is trading at 50$ and we sell the next month out 45$ put for 1$ the premium is paid into our account. If we reach options expiration Friday of the following month and XYZ is above 45$ the one dollar premium is realized as a gain with no obligation remaining on our part.

The cash received from the put premium can be used for anything once realized. Several ways an investor could use premium as an investment include:

• Paying down margin balances.
• Purchasing additional securities.
• Pay off debt.
• Contributing to an IRA or college fund.
• Reduce cost basis.

The premium can also be used before it is realized as a gain. I encourage any investor new to trading options to be cautious in spending the premium before the put expires. A friendly market can become an unfriendly market very quickly. Sticking with our example above lets say our XYZ misses earnings and drops 20%. Now trading at 40$ we have an obligation to buy XYZ at 45$ but the drop to 40$ causes a margin call and we don’t have the funds to cover the call. Now we have to close our position and the 1$ has already been spent. If we can’t afford the margin call we have to close the option position and take the loss of 4$. If the 1$ premium, had it been left in the account, would have been enough for us to avoid the margin call we may have been able to avoid the loss.  By avoiding a margin call we could stay in the trade while waiting for XYZ to move higher. If necessary, we would have also been able to roll the position out another month to give XYZ more time to move higher and potentially received additional premium.

Reduce cost basis –  Get paid to buy a stock at a lower level at which you would be comfortable creating an opening position. Lets say we think trading at 50 XYZ is too expensive but at 45 we would like to buy the stock. We sell the 45 put and receive the 1$ premium. Now we are in a position to either buy the stock at 45 and have a true cost basis of 44, taking into account the 1$ premium, or pocketing the 1$ if XYZ doesn’t drop to 45 be option expiration.

Another more creative way to reduce our cost basis or potentially take advantage of a move higher in the stock would be to sell a deep in the money put. For example let’s say XYZ is trading at 50 and we sell the 53 put for 5$. At first look it may seem counterintuitive to agree to buy XYZ at 53 when it is trading at 50 but after doing the math the trade may become attractive. On expiration day XYZ is still at 50 and we buy at 53 but actually have a cost basis of 48 taking into account the 5$ premium received. On the other hand if XYZ is trading above 53 we received the 5$ premium and don’t have to buy the stock. By selling the deep in the money put we now buy XYZ but at a price lower than it was trading when we opened the position or put 5$ in our pocket without having to pay 50$ per share to buy the stock.

It may seem the more simple trade would just be to buy the 50$ call to take advantage of a move higher in XYZ but with the call we spend money that is lost if the stock doesn’t move high enough to cover the premium cost. With the put you receive premium as opposed to spending money on the call. Keep in mind your risk is capped at the amount of money you spent buying the call while your risk with the put is much greater. Potentially our XYZ stock could go to 0 sticking you with a worthless stock you have to buy at 53. With a deep in the money put trade I encourage an investor to limit their possible downside risk buy using a spread which I explain in strategies.