Beginners Guide To Put Options And How To Trade Them (With Example)

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The stock market is always in motion. There are peaks and troughs, downturns and upturns, and corrections and rallies, depending on how considerable the volatility is. Once you get the hang of the market volatility and can make an educated guess about which direction the stock price will go in, you can up your trading game in the options market and make money in the near term. 

Options Trading Simplified

You often hear options trading is risky, but in reality, options are a business of risk and reward. Risk-averse traders buy options, and risk-taking traders sell options. This risk exchange happens on the options trading platform for a price. Just look at the risk, quantify it, act on it (either take it or pass it), and voila! You are trading options.

The 2022 market downturn has left the portfolio of many traders in red. What if you could make money from this bearish market? Put options trading can help you make money in a dip. 

What Is a Put Option?

A put option is a contract used by options traders for hedging the underlying asset – be it stocks, ETFs, commodities, or currency – from the downside risk. How? Buckle up for some options terminology. 

A put option gives the buyer the right, not an obligation, to sell the underlying asset for a predetermined price (Strike Price) at a future date (Expiration-Date). If the asset price falls below the strike price, the put options buyer can sell the asset to the put option seller at the strike price and gain from the downside. 

The put option seller is obligated to purchase the underlying asset if the option buyer exercises his right to sell. The seller will take the downside risk for a reward (Options Premium). Higher the risk, higher the option price.  

There are two types of put options: 

  • The most common stock option is an American-style option that you can exercise any time before the option expiration. An equity options contract represents 100 shares of the underlying stock. 
  • A standard index option is a European-style option that you can exercise only at options expiration. 

How do Put Options work?

As a put option buyer, you can only make money if the underlying price falls below the strike price. If this happens, your put option is “in the money (ITM).” 

For instance, you buy stock of Tesla for $190, which goes up more than $350. But the market downturn reduces the current stock price to $215. You believe the stock will go down, so you buy a put option for Tesla stock with a strike price of $215, expiring on December 30, 2022, at an option price of $0.50 per share. For a $50 ($0.50 x 100 shares) premium, you get the right to sell the Tesla stock to the put option seller for the exercise price of $215/share. Your option trade achieves a break even at $215.5.

Stock PriceStrike PriceBreakevenOption ProfitOption statusBuyer’s action
$220$215$214.5($550)Out of the moneyMay Not Exercise
$215.5$215$214.5$0At-the moneyMay or may not Exercise
$200$215$214.5$1,450In-the-moneyWill Exercise
Three scenarios for a call option
  • If the stock price rises to $220, your put option expires worthless. Your total loss is the option price of $50. And the put option seller’s total profit is $50. 
  • If the stock trades at the breakeven point of $215.5, you may exercise the put option and reclaim your option premium.  
  • You will stand to make money if Tesla stock trades at $200 at expiration. The intrinsic value of your put option is $15 ($215 strike price – $200 spot price). 

This is just the ABC of a put option. Once you know your alphabet, you can move on to write words, sentences, and paragraphs. Every trade has profit and loss. You can use different trading strategies to control losses and make money.

How To Make Money From Put Options?

When you have an ITM put option, you can make money in three ways: 

1. Exercising puts

When you buy a put option on your existing Tesla shares that you purchased for $190, it is covered put. You can make money by exercising the put option at a $215 strike price.  

Net Profit = $2,450 [(($215 selling price – $190 purchase price) – $0.5 option premium) x 100 shares]

2. Selling puts as they near expiration 

If you don’t want to sell shares, you can sell the put option for a premium and continue holding those shares for the longer term. The put option is $15 ($215-$200) in the money so you can sell this option at a premium of $0.15 per share. 

Net Profit = $1,515 (($15 option value + $0.15 option premium) x 100 shares)

3. Short selling – Exercise deep-in-the-money puts and buy back shares at a lower price

If you don’t own Tesla shares but brought the put option to speculate, you can convert it into a short sale. Here you exercise the right to sell shares at $215 and then buy back at the spot price of $200 to complete the option trade.

Net Profit = $1,450 [(($215 selling price – $200 purchase price – ($0.5 Options premium) x 100 shares] 

Why Should You Buy a Put Option?

The put option is popular among commodity suppliers (oil and agriculture companies) who want to hedge their output from downside risk. But speculators buy put options to earn arbitrage profit from a dip. They may buy a long put (purchasing the put option without owning the stock). 

Using the put option, you can magnify your profits and limit your downside risk for a small premium. In the above example, you spent $50 on a put option to profit when the stock price goes down. Similarly, you can buy a call option to profit when the stock price increases. 

Why Should You Sell a Put Option?

If you are bullish on the stock, you can write several put options with different expiration dates to generate income from the options price. You can also write a put option if you want to buy shares at a particular price. 

For instance, Maya wants to buy Tesla shares for $200/share and has set aside $20,000 for the same. She keeps writing out-of-money put options for a $50 premium. Her fourth put option gets exercised, and she buys 100 Tesla shares for $19,800 ($20,000-$200 earned from four options premium). It is called cash-secured put. 

How To Trade Put Option 

Options trading is more complex than stock trading. You might have to get approval from your brokerage firm to trade options by filling up a questionnaire. Option trading strategies like the naked put, where you sell a put option unhedged, have margin requirements to maintain in your brokerage account. 

Conclusion 

You can make money in a market upturn or downturn. In this article, we touched on the basics of put options. You can merge call-and-put to execute option strategies like a long straddle, short straddle, or Iron Butterfly. As a beginner, it is better to start with buying options and limit your losses to the options premium. As you gain experience, you can move to write secure put options. Options trading is about making money from price volatility responsibly.  

This Options Discord Chat is The Real Deal

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Join the #1 Exclusive Community for Stock Investors

Looking for winning and profitable options trading ideas every day? Click here to apply for a membership with Options Trading Club!

This Options Discord Chat is The Real Deal

While the internet is scoured with trading chat rooms, many of which even charge upwards of thousands of dollars to join, this smaller options trading discord chatroom is the real deal and actually providing valuable trade setups, education, and community without the noise and spam of the larger more expensive rooms. With a incredibly low-cost monthly fee, Options Trading Club (click here to see their reviews) requires an application to join ensuring that every member is dedicated and serious about taking their trading to the next level. If you are looking for a change in your trading strategies, then click here to apply for a membership.


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