What are put options?

A put option is a financial contract giving holders the right, but not the obligation, to sell an underlying asset at a predetermined price (the strike price) by a specific expiration date. Put options can be based on various underlying securities, including stocks, currencies, bonds, indexes, and commodities.

Buyers of a put option pay a premium for the right to sell the asset at the strike price. If the asset’s market price falls below the strike price, the buyer can exercise the put option to sell the asset at a potential profit. They can also sell the option itself. If the buyer chooses to exercise a put option, the seller has an obligation to buy the asset at the strike price.

The role of the exchange in option trading

It’s important to understand that when trading put options on a regulated exchange, the trade doesn’t happen directly between a single buyer and a single seller. Instead, the exchange acts as the central counterparty to every trade. That means the exchange, through its clearing house, steps in between both sides of the transaction.

So when a buyer purchases a put option, their counterparty isn’t the specific seller who initially wrote the contract. Rather, the exchange guarantees performance on both sides. If the buyer decides to exercise the option, the clearing house ensures that the transaction is fulfilled, making sure the asset is purchased at the agreed strike price and the seller meets their obligation.

Who uses put options? 

• Hedgers: Companies and institutional investors commonly use put options as a risk management tool for the underlying asset that they will eventually be selling.
• Speculators: Generally, when buying put options speculators believe the price of the underlying asset will fall below the strike price while sellers believe it may increase or stay the same. Speculators assume risk when placing this wager and add liquidity to the market for other speculators and hedgers.

The other side of options contracts are call options. These give holders the right, but not the obligation, to buy the underlying security at a specified price by the expiration date. Both call and put options are frequently used as part of futures trading.

Put option example

For example, if an investor buys a put option with a strike price of $60 and a premium of $2, the option will be profitable at expiration if the asset’s market price falls below $58. This allows the holder to sell the asset at a higher-than-market price and either offset against a lower asset price (hedger) or secure an outright profit (speculator)

When purchasing put options, investors assess the return on investment (ROI) by comparing the premium paid to the potential profit if the underlying asset's price declines.

How put options work in financial markets

 The basic features of a put option are:

• Underlying asset: The asset on which the option is based, such as a stock, bond, or commodity. This is sometimes referred to as ‘the underlying’.
• Strike price: The predetermined price at which the buyer can sell the asset if they choose to exercise the option.
• Expiration date (Expiry): The date by which the buyer must choose whether to exercise the option or let it expire.
• Premium: The fee paid by the option buyer to the seller.

Most put options use one of two expiration rules, known as American and European options:

• American options: Can be exercised at any time before expiration, giving more flexibility if an option is in the money before expiration. These may include options on standard futures months as well as shorter term instruments such as daily, weekly, or short dated options.
• European options: Can only be exercised on the expiration date, which means the underlying asset can only be delivered at the end of the options’ life.

Despite their names, American and European options refer to exercise rules rather than geographical location. Both types are traded globally on derivatives markets and subject to the same pricing principles.

The two main players in a put option are the buyer and the seller:

Put option buyers

Put option buyers pay a premium for the right, but not the obligation, to sell the underlying asset at the specified strike price on or before expiration. They stand to benefit if the underlying asset's price falls below the strike price before the expiration date. Should this happen, the buyer can choose to exercise the option. This means they'll sell the underlying asset at the above-the-market strike price, earning a potential profit.

If the underlying asset’s market price stays above the strike price, they can let the option expire worthless. In this case, their losses will be limited to the premium paid for the option.

For example, suppose an investment firm holds a substantial position in a company’s stock. The stock currently trades at $100 per share. If the firm is concerned about potential downside risk, they might choose to buy put options with a strike price of $100 for a premium of $5 per share. Since each contract covers 100 shares, buying one put option costs $500. The firm buys 10 contracts to hedge 1,000 shares with a total premium of $5,000.

If the underlying stock price drops to $85 before the option expires, the put option becomes valuable. The firm can choose to exercise the option to sell 1,000 shares at $100 each, even though the market price is only $85, or it can choose to sell back the options and remain long the underlying asset. Their potential profit is the total amount they receive for the shares minus the premium paid for the option.

If the company’s stock price stays above $100, the investment firm can choose to let the option expire worthless, or sell back at any time prior to expiration. Their losses are limited to the premium paid.

Put option sellers

Put option sellers receive a premium in exchange for the obligation to buy the asset at the strike price if the buyer chooses to exercise the put option. If the asset’s market price falls below the strike price, they’re obligated to buy it at the higher strike price and potentially incur a loss.

What factors influence the pricing of put options?

There are two key factors that influence put option pricing, time to expiration and intrinsic value:

Time to expiration

A put option’s value generally decreases as it approaches the expiration date. This is known as time decay. The reason for time decay is that less time to expiration means there’s a smaller window of opportunity for the asset’s market price to move below the strike price. The closer a put option is to expiration, the less time value it has. When a put option loses time value, all that’s left over is intrinsic value.

Intrinsic value

Intrinsic value reflects the difference between the underlying asset’s current market price and the option’s strike price. If the put option’s strike price is higher than the underlying’s market price, it’s considered in-the-money (ITM). This means it has intrinsic value and is worthwhile to exercise.

If the put option’s strike price is the same or lower than the asset’s market price, it’s considered at-the-money (ATM) or out-of-the-money (OTM). These options have no intrinsic value because there’s typically no financial benefit to exercising them.

Put options vs call options: key differences for investors

Call and put options are the two types of options contracts:

• Put options: Put options grant buyers the right, but not the obligation, to sell an asset at a predetermined price by a specific future date. If the buyer chooses to exercise the option, the seller (or writer) must purchase the asset. Investors typically buy put options if they expect the asset’s price to decrease, or sell a put option if they believe it will increase.
• Call options: Call options provide buyers with the right, but not the obligation, to purchase an asset at an agreed-upon price on a future date. Investors can buy call options if they believe the asset’s price will increase, or sell a call option if they believe the asset’s price will decrease.

Call options vs put options

The table below offers a side-by-side comparison between call options and put options.

Risks and considerations when using put options

While put options can offer a way to manage risk, they also come with own set of risks that need to be considered:

• Cost: Put options require paying an upfront premium, which may decline in value if the underlying asset’s price doesn’t move lower prior to expiration.
• Timing: Options have expiration dates and their value will diminish as the expiration date approaches. European options can only be exercised on the expiration date, which means investors cannot capitalize on favorable price movements before that date. With American options, there is a risk that favorable price movements could reverse before the option is exercised.
• Forecasting: When used for hedging an underlying asset, put options can lower the risk in forecasting future price movements, as the owner is protected against adverse moves lower while still being open to participate in market moves higher.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.