Options are leveraged investments that offer the potential to generate large gains or losses over a short time period. The two main types of options are calls and puts. Puts are bets that a stock will go down in price over a certain time period. However, depending how and when you buy or sell a put option, you might be betting for the stock either to go up or to go down. It's helpful to consider exactly how options work and how you might profit from buying or selling them.
When you sell a put option, you are essentially betting that the value of a stock is going to rise in the future. However, when you buy a put, this typically means that you anticipate the value of the stock will fall by the date of option expiry.
How Put Options Work
All options have a month and a price assigned to them. For example, you might see a put option labeled "IBM Dec 100." If you buy this put option, you are buying the right to "put" 100 shares of IBM stock to the buyer of your option at $100 per share before the option expires on the third Friday of December.
Thus, your put option will rise in value if IBM stock goes down after your purchase. The price of your option will accelerate faster if IBM falls below the $100 per share indicated by your put, which is known as the strike or exercise price. If the price of IBM is above $100 per share by the third Friday of December, your put option will expire worthless.
How Are Put Options Priced?
The price of an option can be divided into two components, the intrinsic value and the time value. The intrinsic value of an option is determined by the current value of the underlying stock. Since put options are bets that a stock will go down in value, puts with strike prices above the current market price of the underlying stock are considered to be "in-the-money."
For example, if you own an IBM Dec 100 put and the stock is trading at $95, that put has an intrinsic value of $5, since you could buy the stock for $95 per share and "put" it to someone who must pay you $100 per share.
The time value of an option is always decreasing. As an option heads toward its expiration date, its time value will head toward zero. Thus, options with longer terms have higher intrinsic value. For example, if IBM trades at $95 per share in January, an IBM Dec 100 put will be worth more than an IBM Feb 100 put, since the option has an additional 10 months to show a profit.
When you add together the intrinsic and time values of an option, you'll get the current market price of the option.
Buying vs. Selling Put Options
When you buy a put option, you're making a bet that a stock will trade lower before the option expires.
When you sell a put option, you are making one of two different types of bets. The first way to sell a put option is to close out an existing position that you already bought, at either a loss or a gain. For example, if you bought an IBM Dec 100 put for $4 per contract and the price went up to $9, you could sell your put option and pocket the $5 per-contract gain.
However, you can also sell a naked put. This means you're selling a put not to close out an existing position you already bought but rather to open a brand new position. If you sell a naked put, you are giving the buyer of that put the right to "put" the stock to you at the strike price.
For example, if you sell a naked IBM Dec 100 put, you may be forced at any time to buy IBM stock at $100 per share. However, if IBM never trades below $100 before your December option expires, you won't have to buy the stock and can simply keep the premium you received from the sale of the option. In other words, selling a naked put is the same thing as betting that a stock will go up, not down.