Put Options at Work: A Trader's Guide

The basic elements of the Put option contract are the same as the call option, but with one major difference. The Call options give the option owner the right to buy at the strike price. But the Put option gives the option owner the right to SELL at the strike price.

The example will help to clarify how this works to the benefit of the Put buyer. The example below is based on the purchase of a Put option on stocks, but the concepts of the Put option are the same with whatever financial instrument is used.

First, a quick review of the Put option.

A PUT option is the RIGHT TO SELL the Underlying Asset at the STRIKE PRICE until the option expires.

Since the Put option gives the right to sell the stock at the strike price, a Put option is used when the price of the stock is anticipated to fall. The following example will help to explain how and why the Put option increases in value as the price of the stock falls.

In this example, the purchase of a BSC APRIL 75 Put is discussed. This gives the Put option buyer the right to sell 100 shares of Bear Stearns (BSC | Quote | Chart | News | PowerRating) stock at a price of $75.00 a share. This right exists until the close of trading on the 3rd Friday of April.

For this example, we will say that the decision to buy the Put option was made on March 3, 2008. BSC closed at $77.32

We will also assume that the put is purchased at the last trade price. The option purchase price is known as the premium. In the case of the BSC put, the quote was $5.70 This quote has to be multiplied by 100 to give us the final price of the option. In this case, the option premium would be $570.00.

The option buyer now has control of 100 shares of BSC stock for a total price of $570.00.

Buying a put option benefits the buyer of the option in the same manner as "shorting" BSC stock does. Going short a stock requires having a margin brokerage account. It is also a requirement of going short that the brokerage firm must have BSC stock available to short.

In this case, the Broker will require a 50% margin deposit to allow a short sale of the BSC stock. Therefore, the cash required would be $3866.00 to have 100 shares of BSC stock "short" in a brokerage account.

If the price of the stock rises during this time, the stock short seller will be losing money. For example, if the market price of BSC rises to 79.23 and the short seller decides to buy back the stock, the short seller will have lost $200 on the transaction (assuming an initial short sale price of 77.23.). The more the market price of BSC rises, the greater the potential loss will be.

On the other hand, purchasing a Put option limits the maximum that can be lost to the cost of the option, or $570.00.

Since the option gives the buyer the right to sell the stock at 75.00, any time the stock price is below $75.00, the option is "in the money". When the price of the stock is below the put strike price, the difference is called "intrinsic value". This means that if BSC's current market price is $65.00, the intrinsic value would be $10.00 per share.

The math for this concept looks like this:

The Put Strike Price = $75.00

BSC's Market Price = $65.00

Put's Intrinsic Value per share = $10.00

If the market price of BSC goes to $55.00, the intrinsic value of the option would be $20.00 per share. The option's value would theoretically be $20.00 x 100 = $2000.00

There are other factors present in determining the value of an option over the life of the option, but those factors will be discussed in later lessons.

The premium paid for the option must be included when calculating the potential profit or loss on the purchase of the put option. Since the premium paid for the option was $5.70 per share, this value must be subtracted from the Put strike price to determine the breakeven price of BSC. The math for this break-even point looks like this.

The Put Strike Price = $75.00

Premium Paid Per Share = $ 5.70

Stock Break Even Price = $69.30

Now, with all of this in mind, what happened when BSC closes at 10.49 on April 1, 2008?

For one, the Intrinsic value of the Put increased dramatically

The Put Strike Price = $75.00

BSC Market Price = $10.49

Put's Intrinsic Value per share = $64.51

The original premium of $5.70 a share ($570.00 total premium paid) is now worth $64.51 a share. ($6451.00 value).

The option has increased in value by $58.81 per share, for a $5,851.00 total increase. Using leverage resulted in an return of 1,032% over 20 trading days.

The total dollar return on the short sale of the stock would have been higher since the stock could have been shorted at $77.23 and covered for $10.49. The total dollar return would have been $66.74 a share or $6,674.00. The return over the same 20 days doing a short sale instead of buying puts as described above would have been 58%.

If BSC stock had not gone down in price over this time, but instead had risen to 97.23 a share, the maximum loss on the option could still not exceed the original $570.00 premium paid. Shorting the stock on margin, in contrast, would have resulted in a loss of value of $2000.00.

This is just one example of a Put option purchase. The results reflect the actual change in Price in BSC stock during the period of March 3, 2008 to April 1, 2008. The actual prices of the option varied slightly but not enough to change the results shown in the examples.

John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.