Put Option: What It Is, How It Works, and How to Trade

What is a put option?

A put option is a derivative contract that gives the holder the right, but not the obligation, to sell an underlying asset (stock, ETF, commodity, bond, index, currency, etc.) at a specified price (the strike) on or before a predetermined date (expiration). A put is the counterpart to a call option, which gives the right to buy.

How a put option works

• A put increases in value when the underlying asset’s price falls; it loses value when the underlying rises.
• The holder can either sell the put prior to expiration to realize gains or exercise the option to sell (or establish a short position if they do not own the asset).
• Investors commonly use puts to hedge downside risk (a protective put) or to speculate on price declines.

Key pricing components

A put’s market price (premium) consists of:
– Intrinsic value = max(0, strike − underlying price). (If > 0, the option is in the money, ITM.)
– Time (extrinsic) value = premium − intrinsic value; it reflects remaining time to expiration and expectations of future volatility.

Other factors that affect a put’s value:
– Underlying price movements
– Time to expiration (time decay accelerates as expiration approaches)
– Implied volatility (higher volatility raises premiums)
– Interest rates and dividends (smaller influences)

Important relationships
– Out‑of‑the‑money (OTM) and at‑the‑money (ATM) puts have no intrinsic value.
– Time decay reduces extrinsic value; options often lose value as expiration nears.
– For a put buyer, maximum loss = premium paid; maximum theoretical gain = strike (if underlying falls to zero).

Common uses and strategies

• Protective put: Buy a put on a stock you own to cap downside losses while retaining upside.
• Speculative long put: Buy a put to profit from an expected fall in the underlying price with limited capital outlay.
• Put writing (selling): Collect premium by selling puts. If the option is exercised, the writer must buy the underlying at the strike price.

Writing (selling) put options

• A put writer receives the premium as maximum profit if the option expires worthless (OTM).
• If the underlying falls below the strike, the writer may be obligated to buy the asset at the strike, potentially incurring large losses. The maximum theoretical loss equals the strike price (per share) if the underlying falls to zero.
• Cash‑secured puts: a conservative variant where the seller earmarks cash to buy the underlying if assigned.

Selling vs. exercising

• Most long option positions that are in the money before expiration are closed by selling the option rather than exercising it.
• Selling captures both intrinsic value and remaining time value.
• Exercising converts the option into actual stock transactions, which often involves higher commissions and margin impacts.
• Writers who face rising risk can buy back the option to close the short position.

Example (simplified)

• Buy 1 SPY $545 put expiring in one month for $2.80 (premium = $280 per contract).
• If SPY falls to $535 before expiration:
• Intrinsic value = $545 − $535 = $10 (option trades at least at $10).
• If the put’s market price is $10.50, selling it yields profit = ($10.50 − $2.80) × 100 = $770.
• Exercising and then closing resulting stock positions typically yields less profit because exercising discards remaining time value.

Comparing put buying and short selling

• Both are bearish, but differ in risk and capital requirements:
• Put buyer: limited loss (premium), no margin requirement in many cases, lower carrying costs.
• Short seller: theoretically unlimited loss, requires margin, can incur borrow fees and interest.
• Buying puts is generally safer and more capital‑efficient for bearish exposure.

Practical considerations

• Where to trade: Options trade through brokerages—choose one that fits your trading needs and experience.
• Alternatives to exercising: Sell the option in the market to lock in gains or limit losses.
• Risk management: Understand payoff profiles; be aware that writing puts requires sufficient capital and risk tolerance.
• New traders: Writing puts and other advanced strategies are typically not recommended for beginners or those with limited capital.

Frequently asked questions (brief)

• Can I lose the entire premium? Yes—if the underlying never falls below the strike by expiry, the put can expire worthless.
• Should I choose ITM or OTM puts? ITM puts cost more but have a higher probability of intrinsic value at expiration. OTM puts are cheaper but need a larger move to become profitable. Choice depends on objectives, risk tolerance, and capital.
• Is put writing appropriate for new investors? Generally no—writing puts carries significant risk and can require large capital reserves (e.g., for cash‑secured puts).

Bottom line

Put options are fundamental derivatives that provide downside protection or bearish exposure with a defined loss (the premium) for buyers. They are versatile tools for hedging and speculation but carry distinct risks for sellers. Understanding intrinsic vs. extrinsic value, time decay, and the differences between buying and writing puts is essential before trading options.