A put option is a security that you buy when you think the price of a stock or index is going to go down. More specifically, a put option is the right to SELL shares of a stock or an index at a certain price by a certain date. That "certain price" is known as the strike price, and that "certain date" is known as the expiry or expiration date.
A put option, like a call option , is defined by the following 4 characteristics:. It is called an "put" because it gives you the right to "put", or sell, the stock or index to someone else. A put option differs from a call option in that a call is the right to buy the stock and the put is the right to sell the stock. So, again, what is a put? Since put options are the right to sell, owning a put option allows you to lock in a minimum price for selling a stock.
It is a "minimum selling price" because if the market price is higher than your strike price, then you would just sell the stock at the higher market price and not exercise it. Look at the graph at the lower right and note the shape of the payoff curve for owning a put option.
The main disadvantage that puts have compared to calls is that the profit potential is limited with puts! So the most that a put option can ever be in the money is the value of the strike price.
This contrasts to calls, where the stock price theoretically can go to infinity so the profit potential from a call option is unlimited.
This is one reason that puts have less appeal and less volume than calls; the other reason that puts typically have less volume than calls is that the natural trend of the market is up so most people are expecting stocks to go up so they buy calls. If you think a stock or index price is going to go down, then there are 3 ways you can profit from a falling stock price:. The first example is if you believe that a stock price is going to fall in the near future. Maybe the stock has gone up too much too quickly.
Or suppose you know that a stock is about to release bad earnings or report some other bad news. If this is the case, then you best way to make money in the short term is to just buy a put option on the stock.
The strike price and the expiration month that you choose depends on how far you think AAPL will drop and when you think it will drop. Also suppose you found out from a friend that knows for certain that the sales are down and profits are down. You would buy the nearest expiration month because that would be the cheapest, and you would buy the nearest strike price under the current market price because that is where you tend to get the greatest percentage return.
Here's another example of why a lot of people trade put options. In this instance you still own the stock and have taken a similar loss on owning the stock, but that loss on the stock is offset 1: Put Option Trading Tip: Why buy a put option if you own the stock and you think the price will decline?
Many people in this instance would just sell the stock, let it drop, and then buy the stock back at a lower price. The problem with this strategy is that you would have a huge capital gain on the sale of the stock and you would have to pay taxes on that gain.
If you just buy a put, that is a totally different transaction as far as the IRS is concerned so you would just have to deal with the tax consequences of that put option trade. So if you own stock at a very cheap cost basis and you think a stock price will decline for the short term, but you still want to hold onto it for the long term, then buy a put option! The taxes on the put trade will be less than the taxes on the stock if you had purchased the stock at a very low price.
That is why it is called an option--it is a choice and not an obligation. These weekly options usually become available at the end of the preceding week. If you are just getting started trading options, then stay away from the weeklies as they are very volatile. Here are the top 10 option concepts you should understand before making your first real trade:. What are Stock Options? What is a Stock Option? What is a Call Option? What is a Put Option? Put Option Examples Related Terms: What are Call Options?
Put Option Payoff Diagram. Here are the top 10 option concepts you should understand before making your first real trade: What is a Call? What is a Put?More...