How Does a Put Option Work?

by Allen Young ; Updated July 27, 2017
How Does a Put Option Work?

Definition

Put options are a financial contract between two parties which gives the buyers of a put option the right to sell an underlying asset at a predetermined price. They can sell the stock at the predetermined price until the contract expires. Usually, put options are associated with stocks, but they can also apply to other financial assets such as commodities. While the buyers have the right to sell the stock at the the contract price, they are not obligated to do so.

Types Of Put Options

There are two types of put options, American put options and European put options. The difference is how the option is exercised by the put holder. With the American put option, the holders can exercise their option up to the expiration date. The holders of the European put option can only exercise their option within a specific time period just prior to the contract's expiration.

When To Use A Put Option

An investor may purchase a put option on a stock if he wishes to acquire the stock but only at a cheap price. If the price declines he can exercise his option and acquire the stock at a cheaper price. If it does not decline he loses only the premium or the amount he paid for the contract. A put seller or the writer of the put who owns the underlying stock may sell a put to pick up additional income if he believes the stock will be stable or the price may rise. In this case, he still owns the stock and receives the proceeds from selling the put option

Using Put Options To Hedge

One common usage of put options is for the owner of the stock to hedge his position to protect himself should the stock price falls. This is done to protect the owner's profit. If the price falls, the investor can sell his position at the higher contract price protecting his profits. The investor can also sell a put contract, and the income from the sale can offset some of the loss from the stock price.

Other Put Strategies

Some investors buy or sell put options as part of an option spread. In this case, they buy or sell puts while buying or selling call options or a contract to buy stocks at the same time. They hope to profit no matter how the stock price performs. This is a very complicated and advanced investment strategy.

About the Author

Allen Young is an experienced writer on such subjects such as real estate investing, mortgages, and personal finance. Young has also written on sports, travel, and parenting. Currently he is the president of Crestwood Capital Group.

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