Definition:
Puts options are financial contracts or instrument (option) that give the holder the right, to sell a specific underlying asset or finance instrument at a pre-determined price (strike price) within a specific period of time.
key take out: "The holder has the right, but not the obligation, to sell."
" 1 option is considered *100 worth of the financial instrument to be traded."
For general and more understanding see Options trading
Puts options are used in trading and stock market. In this blog we are going to explore the basics and example of how put options are used:
How do Put Option work? - Understanding Put Options.
In this we are going to see how Put Options work with a use of an example.
A trader buys one option for company shares selling at $100 at a strike price $90, for a duration of 3 months. The premium paid for the option was $200. What may be the different outcomes of the trade?
outcomes of Put Options
In the money
Say the stock price of the company are selling at $85. The trader will be at the money since the trader can exercise the contract for eccentric value it has gained over at the end of expiration time.
how to calculate the profit:
old share price = $100
new share price = $85
strike price = $90
premium paid = $200
price per share = $2 ($200/100)
100 - 85 = 15
100 - 90 = 10
10 + 2 = $12
$15 - $12 = $3 : this is the profit realized per share
$3 * 100 = $300 :total profits gained by the trader.
At the money
Say the current stock market price of the company sells at $88. The trader will be at the money as no gain will be realized. However the trader will not loose the money invested.
Out of the money
Any outcome that will be above $88, will make the trader be out of the money. Since the contract will not have gained any value, there will be need to exercise the contract. The trader will loose the premium paid that's all. Also since the trader has the right to sell and not obligation, the trader will not be required to buy the stock at the current market price.
from the above trade $88 is the price that determine the outcome. Above $88 the trader will loose the premium, At $88 the trader will neither loose nor gain and below $88 the trader will have broken even at profit will be realized as prices decline.
Uses of put option / Advantages of Put Options
1. Used to speculate.
Put Options can be used for speculative purposes. A holder of a Put Option may buy it with the hope prices of the bought instrument will lower its price. This will enable them to sell the contract at a higher price than the one currently offered at market price.
2. Used for hedging.
Put Option may be used as hedging tool. Investor who are concerned of potential decline of stock value they own. For example, if an investor owns shares of Company D and is concerned that the stock may decrease in value, they may buy a put option with a strike price below the current market price of the stock. This would give the investor the right to sell the stock at a higher strike price if the market value of the stock decreases.
3. Used as income generating tool.
By constant use of the put option in the right manner the trader tend to make a continuous flow of income in the portfolio.
Disadvantages of Put Options.
1. Can be risky.
Just like any other trades, trading on Put Options has the risk of loosing high amount of money in the portfolio.
2. Not for every person.
To open a Put Option account, the buyer has to approved by the broker to hold one. This is because of the requirement and hurdles for one to qualify to be Put Option trader.
3. Time consuming.
To analyze the market to come up with the right data to invest in Put Option is time consuming. This is from amount of information to be gathered and analysis to be done to come up with the right signal.
4. May result in short-term gains with high fees.
Since most trades are based on days or months, this will enable the trader to have quick short term gains. This will have a ripple effect of attracting many fees and commissions to open and run this trades. Also depending on the jurisdictions the trade taking place there may be taxes associated with each trade.
5. Limited by time.
This is by the value of time set as expiry date. If the trader were to set the expiry date as 6 months, then the contract is bound to expire at the end of the 6 months period.
In conclusion, puts options are a useful tool for managing risk in the stock market and can also be used for speculative purposes. However, it's important for investors to consider the expiration date, strike price, and potential risks before making any investment decisions. As always, it's important to do your own research and consult a financial advisor before making any investment decisions.
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