Are you a stock trading rookie? Finance lingo can be hard to understand. It is only natural to find it tricky to navigate the definitions and dynamics of assets such as stocks, investments, and currencies. We make understanding put options simple.
Options are the derivatives or contracts that give a person the right, but not the obligation, to buy or sell stocks at the strike price before an expiration date. These allow you to collect premiums per stock share.
In simpler words, options are financial, legal documents that can be bought or sold for a definite price before a specific date for some profit.
There are two types of options in the stock trading world- call options and put options.
If you want a quick, comprehensive, and easy guide to put options, read this article.
Key Definitions
To understand put options better, you should tune yourself to understand a few fundamental definitions. We’ve listed the essential ones down below using relatively simple vocabulary.
- Derivatives: A financial contract or agreement that assigns value to the stock or asset.
- Contract: A legal document signed by two or more parties confirms the rules of an agreement between them.
- Stocks: Proof of part-ownership of investments, assets, or equity,
- Strike Price: The price of the asset on the day of the contract.
- Expiration Date: The last date to evaluate the market price of an asset.
- Shares: Unit of quantifying stocks (in amount).
- Premiums Per Stock Share: The profit earned for each stock share. At the end of the expiration date, it is calculated by 100 stock shares unless specified otherwise (e.g., 150 stock shares are worth $15,000).
Put Options Defined
Options are the contracts that allow you to buy or sell stocks or assets in the market. Call options are the contracts that facilitate buying and put options, selling.
Put options, therefore, are financial derivatives or contracts that enable people to sell stocks at the strike price (market price) before an expiration date.
Buyers of the put options are betting on the decrease of the value of specific stocks.
By buying a put option, you would assign part-ownership of stock to yourself. This means that you would now hold financial responsibility for the losses and profits earned.
Put options have a lower loss potential and a higher profit potential. This makes them a regular avenue for stock market traders. Buyers would ideally want the stock value to reduce quickly.
This basically means that put options are usually signed by a buyer when they are confident that an asset’s value will decrease. By this, the buyer of the put option will earn some profits.
Let’s look at how this works.
Understanding Put Options
Put options and the profits earned by bidding on its stocks are directly influenced by the stock’s strike price or market price when the buyer first obtained it.
As mentioned earlier, put options have a lower loss potential and higher profit potential. If the stock’s value decreases, you will be able to sell the stock for a higher rate than what it’s actually worth.
The difference between the initial strike price and the fallen stock price is called the intrinsic value. The intrinsic value should always be below the strike price while purchasing a put option.
If you buy a stock for 200 stock shares, it means that one unit of the 100 stock shares is worth $200. The total stock share value is $20,000.
Let’s consider you bought a put option for a stock worth 200 stock shares today. The value of the stock drops to 175 stock shares by the end of 30 days which is the expiration date as per the put option. The intrinsic value of the stock here is 25 stock shares.
At the end of 30 days, you still retain the right to sell the stock at 200 stock shares. Your net profit, at this point, would be 25 stock shares which when calculated (per 100 stock shares) is $2,500.
The profits are yours, but the other party is now entitled to present the stock at 175 stock shares for the next buyer. And so, the cycle continues.
Losing Money Through Put Options
Yes, it is also possible to lose money with put options.
This occurs when the value of the stock increases before the expiration rate. In such a case, you would be able to sell the stock for the price you bought it at and not the current market value.
The difference between the expected intrinsic value and the increased stock price is the extrinsic value.
Two main external factors affect the extrinsic value- time and volatility. If a stock has more time or is more volatile to change, this may affect its stock’s market value.
Let’s consider that you bought 200 stock shares and assess the intrinsic value to be at 175 stock shares. With time and trends, the stock value increases to 225 stock shares at the end of 30 days, our expiration date.
You now only have the right and capability to sell the stock at 200 stock shares and not 225. By this, you would be making a loss of 25 stock shares on this stock. That amounts to $2500 when calculated per stock share.
The losses are yours, but the next bidder can now present the market value for 225 stock shares. They have ultimately generated a profit of 25 stock shares through you.
To Summarize,
Put options are low-risk investments for stock market traders and investors. They enable to earn profits and also evaluate market trends and risks.
While there are risks involved, most regular stock traders invest in put options to retain profits. You can make big bucks quickly and easily with put options.
By buying put options, you can only hope that the market value decreases before the stipulated time. You can, however, assess this through various technological apps and websites too. This increases your chances of earning some profits in stock shares.
Now that you understand put options better, it’s time to go invest!