What It Is and How It Works in Investing, With Examples

What Is a Put?

A put is an options contract that gives the owner the right, but not the obligation, to sell a certain amount of the underlying asset, at a set price within a specific time. The buyer of a put option believes that the underlying stock will drop below the exercise price before the expiration date. The exercise price is the price that the underlying asset must reach for the put option contract to hold value.

A put can be contrasted with a call option, which gives the holder to buy the underlying asset at a specified price on or before expiration.

The Basics of Put Options

Puts are traded on various underlying assets, which can include stocks, currencies, commodities, and indexes. The buyer of a put option may sell, or exercise, the underlying asset at a specified strike price.

Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. They are key to understanding when choosing whether to perform a straddle or a strangle.

The value of a put option appreciates as the price of the underlying stock depreciates relative to the strike price. On the flip side, the value of a put option decreases as the underlying stock increases. A put option’s value also decreases as its expiration date approaches. Conversely, a put option loses its value as the underlying stock increases.

Because put options, when exercised, provide a short position in the underlying asset, they are used for hedging purposes or to speculate on downside price action. Investors often use put options in a risk-management strategy known as a protective put. This strategy is used as a form of investment insurance to ensure that losses in the underlying asset do not exceed a certain amount, namely the strike price.

In general, the value of a put option decreases as its time to expiration approaches due to time decay because the probability of the stock falling below the specified strike price decreases. When an option loses its time value, the intrinsic value is left over, which is equivalent to the difference between the strike price less the underlying stock price. If an option has intrinsic value, it is in the money (ITM).

Out of the money (OTM) and at the money (ATM) put options have no intrinsic value because there would be no benefit of exercising the option. Investors could short sell the stock at the current higher market price, rather than exercising an out of the money put option at an undesirable strike price.

The possible payoff for a holder of a put is illustrated in the following diagram:

Puts vs. Calls

Derivatives are financial instruments that derive value from price movements in their underlying assets, which can be a commodity such as gold or stock. Derivatives are largely used as insurance products to hedge against the risk that a particular event may occur. The two main types of derivatives used for stocks are put and call options.

A call option gives the holder the right, but not the obligation, to buy a stock at a certain price in the future. When an investor buys a call, she expects the value of the underlying asset to go up.

A put option gives the holder the right, but not the obligation, to sell a stock at a certain price in the future. When an investor purchases a put, she expects the underlying asset to decline in price; she may sell the option and gain a profit. An investor can also write a put option for another investor to buy, in which case, she would not expect the stock’s price to drop below the exercise price.

Example—How Does a Put Option Work?

An investor purchases one put option contract on ABC company for $100. Each option contract covers 100 shares. The exercise price of the shares is $10, and the current ABC share price is $12. This put option contract has given the investor the right, but not the obligation, to sell 100 shares of ABC at $10.

If ABC shares drop to $8, the investor’s put option is in the money (ITM)—which means that the strike price is below the market price of the underlying asset—and she can close her option position by selling the contract on the open market.

On the other hand, she can purchase 100 shares of ABC at the existing market price of $8, and then exercise her contract to sell the shares for $10. Disregarding commissions, the profit for this position is $200, or 100 x ($10 – $8). Remember that the investor paid a $100 premium for the put option, giving her the right to sell her shares at the exercise price. Factoring in this initial cost, her total profit is $200 – $100 = $100.

As another way of working a put option as a hedge, if the investor in the previous example already owns 100 shares of ABC company, that position would be called a married put and could serve as a hedge against a decline in the share price.