Put Option, How It Works and Examples of Buying and Selling

In the world of finance, when we talk about put options we are referring to an important and very widespread tool for market operators. In the various investment strategies, investors have the opportunity to protect themselves from downside risks or to speculate on potential drops in the prices of underlying assets thanks to option put.

Understanding how put options work is, therefore, essential for anyone who wants to expand their trading and risk management strategies.

What is a put option?

A put option is a financial instrument that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price by a specific date.

This contract offers investors the opportunity to protect themselves from potential losses or to speculate on bearish market movements. Put options are especially valuable in times of volatility, acting as an insurance policy for the investor’s portfolio.

The value of a put option is made up of two main elements: intrinsic value and time value.

• intrinsic value represents the difference between the strike price and the current market price of the underlying asset.
• time value, on the other hand, reflects the potential for future price movement of the asset before the option expires.

It should be noted that put options come in two main styles: European and American.

• European put options can only be exercised on the pre-determined expiration date. This means that the holder has a limited window of time to decide whether to exercise their right to sell.
• American put options, on the other hand, offer more flexibility, allowing the holder to exercise the option at any time between the purchase date and the expiration date.

How Put Options Work

Put options are financial instruments that give the holder the right to sell an underlying asset at a predetermined price by a specific date. There are three key elements to how these options work:

• underlying: the financial asset on which the option is based, such as stocks, indices or commodities;
• strike price: the predetermined price at which the holder of the put option has the right to sell the underlying asset;
• premium: the cost that the buyer pays to the seller of the put option to obtain the right to sell.

The premium of the put option is influenced by various factors, including the current price of the underlying, market volatility, the time remaining until expiration and interest rates. These elements help determine the overall value of the put option and its attractiveness to investors.

Exercising a put option is convenient when the market price of the underlying is lower than the strike price. In this case, the option is "in the money" (ITM). For example, if a stock is quoted at €20 and the strike price of the put option is €25, exercising the option allows you to sell the stock at a price higher than the market price.

Profit and loss scenarios

• For the buyer of a put option, the maximum profit is theoretically unlimited (until the underlying reaches zero), while the maximum loss is limited to the premium paid.
• For the seller, however, the maximum profit is the premium received, while the potential loss is significant but not unlimited, since the underlying cannot assume negative values.

Practical examples of sale and purchase

To better understand how put options work, let’s look at a practical case study. Suppose we are apple growers and we want to insure ourselves against possible price variations at the time of sale. Thanks to the purchase of a put option we have the right to sell a certain quantity of peaches (e.g. 100 quintals) at a pre-established price (e.g. €70 per quintal) at a certain expiry date (e.g. December 2025). The cost of our put option is the premium (e.g. €1.5 per quintal).

Who will collect this premium? The person who issues this option... So, by paying this premium of €150 (€1.5 x 100 q) we buy the right to sell the apples at €70/q to the counterparty who issued the option on the expiry date set out in the contract (March 2025).

At expiration we can have this situation:

1. the market price is less than €70, for example €60. We can sell our apple crop always at €70;
2. the market price is higher than €70, for example €80. We will avoid exercising the option (writing the cost of the put option in the balance sheet), selling the crop at the market price.

We can also make an example relating to financial assets. Suppose we have a bearish view on Microsoft stock in three months. Today the stock is quoted at $40 but our forecast is that it could also fall to $35 or even $25. Therefore, we decide to buy a put with strike $40, expiration in three months, paying a premium of $2 per share.

Let’s recap our position:
- Underlying: 100 Microsoft shares
- Strike Price: $40
- Expiry: march 2025
- Premium: $2

It is clear that if we had purchased the 100 Microsoft shares without using the options, our outlay would have been $4,000. With the purchase of a put, the total outlay is $200 (maximum risk). A big difference, especially from the point of view of controlling the risk of the operation.

Trading strategies with put options

Put options offer investors different strategies to protect the portfolio, speculate on market declines and combine with other options to obtain specific results. One of the most common strategies is to protect the portfolio through the purchase of put options. This technique, known as a "protective put," allows investors to limit potential losses in the event of a market decline, acting as an insurance policy for their portfolio.

To implement a protective put strategy, the investor buys a put option on a stock or index that they already own. If the price of the underlying asset falls below the strike price of the put option, the investor has the right to sell the asset at the predetermined price, thus limiting losses. However, it is important to note that this protection comes at a cost, represented by the premium paid for the put option.

Another popular strategy is speculating on market declines using put options. Investors who expect the price of a stock or index to fall can buy put options to profit from that movement. If the price of the underlying asset falls, the value of the put option increases, allowing the investor to realize a profit.

Put options can also be combined with other options to create more complex strategies. For example, the "collar" strategy involves buying a put option and simultaneously selling a call option on the same underlying. This combination limits both potential losses and gains, offering low-cost protection.

Market Scenario Analysis

Put options are classified based on the relationship between the strike price and the market price of the underlying.

• A put option is in-the-money (ITM), as we have seen, when the strike price is higher than the current market price of the underlying security. In this case, the option has a positive intrinsic value.
• On the other hand, a put option is out-of-the-money (OTM) when the strike price is lower than the market price of the underlying. OTM options have no intrinsic value and will expire worthless if the underlying asset price does not fall below the strike price.
• Finally, a put option is at-the-money (ATM) when the strike price is equal to the market price of the underlying asset.

Furthermore, it should be noted that volatility has a significant impact on the value of put options. Higher volatility implies a greater likelihood of large fluctuations in the underlying asset price, increasing the value of put options. This is because it increases the chance that the option will end up in-the-money at expiration. As a result, in periods of high volatility, put option premiums tend to be higher. It is important to note that volatility primarily affects the time value of the option, not its intrinsic value.

Original article published on Money.it Italy. Original title: Opzione put, come funziona ed esempi di acquisto e vendita