Option Basics Part 2: Buying A Put Option
How Buying a Put is a Protective Hedge
Put options tend to be less intuitive to people than call options. When you buy a naked call option you are speculating on the price of a stock going up. You can make huge returns if right, but lose 100% of your investment if wrong. (Option Basics Part 1: Buying A Call Option covers this). It is fairly easy to understand.
Buying a Put option is speculating on the price of a stock going down. The payout is very similar to buying a call option, but you profit if the stock goes down instead of up. You can make large returns when right, but you lose 100% of your investment if wrong. (Just like with calls).
This post will cover put options without the terrible, dry academia pictured below. Option pricing formulas are useful to know if you need to model options. But you can intuitively understand every aspect of options without ever having to use a Normal Distribution Table.
What Is A Put Option?
Buying a put option is making a bet that a stock or ETF will go down.
Profiting as a stock goes down is known as being ‘short’ the stock. (Not to be confused with ‘shorting’ a stock where you borrow a position on margin to sell and have unlimited losses).
The textbook definition is, “Buying a put option gives you the right, but not the obligation, to sell the underlying at a given price (strike) at a given point in time (maturity)”.
Intuitively, put options tend to be a bit more confusing to people. You buy the right to sell a stock at a given price. Therefore, the put you purchased goes up in value when the stock goes down in value. An example helps clear things up, but before that I want to expand a bit.
The put you purchased allows you to sell a stock at $5. If the stock goes up to $7, you wouldn’t exercise your put and sell at $5. You can sell in the market at $7. Therefore, there is no value in your right to sell at $5 and the put expires worthless.
If you think a stock trading at $5.50 is going to decrease in price you could buy a $5 put. If the price of the stock goes down to $4 at maturity you profit. Your broker most likely will buy $400 of the stock for you and send it to a counterparty in return for the $500 strike price on the put. (Takeaway here is buying a put doesn’t require you to hold the shares or even enough cash to make the purchase. You would just see $100 show up in your cash account on maturity).
Being Naked, Short, and Shorting
Three quick definitions before getting into this post:
Buying a ‘naked put’ means your only position in the underlying is the put you own. You don’t own shares of the underlying stock, or other options on the underlying stock, etc.
Shorting a stock is when you borrow shares from a broker, for a fee, and sell them. At a future date you need to return the shares to the broker, so you will need to buy them back at the market price.
If the price goes down, you buy them back cheaper than you sold them and profit.
If the price goes up, you buy the shares back higher than you sold them and lose. Therefore, shorting a stock has the potential for unlimited losses, margin calls, and can bankrupt you.
When you are shorting a stock you are taking a short position in the stock, but not all short positions require ‘shorting’ the stock. For instance, buying a put is being short the stock.
The mechanics of shorting a position are interesting to be honest. If you guess wrong, you start losing money at an increasing pace due to the position growing. It is the opposite of when you buy a stock and it goes down. Each 10% move against you gets more painful when short. (Outside the scope of this post)
Being ‘short’ a stock just means you profit when the price of the stock decreases.
I agree, it takes a while to be able to get the nuance of being short and shorting when in conversation. For the purpose of this post, just remember ‘buying a put is being short the underlying, but not shorting the underlying’.
Buying A Put Option Example:
Below is a simple example to help you visualize what happens when you buy a put option. We are looking at a stock that is currently priced at $5.50 a share on Jan 15. You purchase a put that expires in 1 month with a $5 strike price. The cost of the option is $0.30. There are 5 scenarios shown with different prices of the stock on the maturity date and your resulting profit.
First, since you are buying a put, you are paying a premium upfront. Looking at the 3rd column ‘option cost 1/15/22’ you will see $30 payment even though the price of the put is only listed as $0.30. Remember, options are quoted on 1 share, but trade in 100 share lots.
The medium, high, and very high scenarios all end with your $5 put option expiring worthless.
This means that if the medium scenario occurred you were correct that the $5.50 stock price was going to decrease. However, the stock price didn’t decrease enough to make your put profitable. You could exercise your put for $5.00 and your broker would get 100 shares for $500 and let you sell them at the $5 strike. But that just results in a net of $0 (buying for $500 and then immediately selling for $500).
However, if the stock price drops below $5, your put ends up ‘in-the-money’ and you make a profit. In the low scenario, you are able to purchase a stock for $3 in the market that you have the right to sell for $5, netting you a $170 net profit after accounting for the $30 premium you paid upfront.
One difference between buying a call and buying a put is the max upside. Technically buying a call has no upside as stock prices can keep ripping higher. Puts do have a capped upside. The lowest a stock can go is $0, therefore there is a max profit when you buy a put. Stocks can’t go negative.
Put Option Buyer’s Profit
The profit and loss of buying a put is shown below. If you remember the profit chart from Part 1: Buying a Call, this will look like a mirror image. Being long a put and being long a call have the same payoff patterns but puts are more profitable as stock price goes down and calls are more profitable as stock price goes up.
The profit & loss from buying a put option is shown in the graph below. The gain on the option is on the y-axis and the price of the underlying stock is on the x-axis. The orange line shows how the put option buyer’s profit increases as the price of the underlying stock changes from $0 to $10.
Takeaways from the put option buyer’s profit graph include:
At all stock prices above the strike price of $5, the option position expires worthless and the net loss is the $30 premium
The option profit decreases as the stock price increases from $0 until the stock price = strike price. The loss on the option then remains at your max exposure no matter how high the stock price goes. Max exposure = premium paid = $30
When stock price = strike price - option premium, the option starts becoming profitable (crosses the x-axis, $4.70 stock price in the above example).
The option payout increases dollar-to-dollar with the decrease in stock price below $5
Unlike calls, there is a max gain for buying a put option. The max profit is if the underlying stock goes to $0 and the profit = Strike Price - Premium.
Risks of Buying A Put Option
Honestly, the biggest risk is that the stock market has been set up into a giant dollar cost averaging ponzi. If you have a 401(k) or IRA you are likely very limited in your investment options. You can’t open a short position on the SP500 in your 401(k). Therefore, every paycheck you have huge swaths of the country dutifully putting in some percent of their money to going long an index ETF. Most likely a market-weighted ETF that indiscriminately buys. So there is a constant buy pressure on the stock market.
Additionally, timing the market is notoriously hard. And options get very expensive as you go further out in maturity.
Is Buying a Put Option Useful?
I made you read all the way to the end to say that I rarely buy naked puts.
Out of the 4 basic option strategies, buying puts is the one I use the absolute least. (The 4 basic strategies being: 1) Buy a Call, 2) Sell a Call, 3) Buy a Put, 4) Sell a Put).
Put options tend to be more expensive than they ‘should’ due to investor risk aversion. Additionally, There are much better ways to hedge positions, in my opinion. (I’d sell ATM or ITM covered calls or even use an inverse ETF with all its design flaws. Keep following and you will likely learn about both).
The above statement being said, buying puts can be an integral part of some of the more complex option strategies. If you are going to get into combination option trades, you need to know how being long a put option works. (Combination options are Bear Put Spreads, Protective Collars, Straddles, etc.)
But most important, learning about buying a put will help you understand how to sell a put. Whereas I rarely buy a put, selling puts is one of my core strategies. All the reasons buying puts sucks makes selling puts great. (Buying puts sucks because of high premiums, most investors only able to take long positions, etc.)
What Are The Reasons to Buy a Put Option?
When you buy a put option, you profit when the underlying stock decreases. There are a few different reasons an investor would buy puts:
Take a short position on a stock- If you want to speculate that a stock price will go down you can buy a put. Buying a naked put is taking a short position in a stock. But unlike shorting, you have a known maximum loss. The most you can lose is the option premium you pay. However, the lower maximum loss comes with the trade-off of having a limited time before the option matures.
To hedge downside risk - There is a strategy called ‘protective puts’ that entails constantly buying a put on an asset you own. If your stock goes down, your put position pays out and you can offset losses. However, this requires constantly purchasing puts which drains some of your returns overtime.
Its outside the scope of this post, but a ‘protective put’ position has same profit as buying a call and therefore is also called a ‘synthetic call’ in places. Since you have the put & call buyer’s payoff graph, you can try to prove it yourself visually
As part of a larger strategy around options/arbitrages/etc.
Buying A Put Option Summary
To summarize buying a Put Option means:
You want the stock price to go down before the maturity date
Your max loss is the price you paid to buy the put
Your max gain is if the underlying stock goes to $0 and it is equal to the strike price minus the premium you paid
The option value increases $-for-$ as the underlying stock decreases below the strike price
Even though a put option is less intuitive than a call option, it is fairly easy to understand. If the market seems frothy, instead of selling positions and moving to cash, you can now buy put options to protect you on the downside.
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