07:52 AM, 24 Feb 2017 (AUS EST)   The market is currently closed       

Put Options Explained

As we learned in Part 1, a Call option is an agreement that positions you as a middleman between the seller and the open market. You have a contract with the owner of the asset. Your agreement stipulates an expiration date when the contract is void and a locked in purchase price(strike price). If the market picks up, you profit from the difference between your agreed upon price in the contract (strike price) and what you can sell it for (current market price). Buying Call options is much like being a real estate agent working on commission hoping for the market to go up in value.

What are Put options?

Put options are purchased when you feel the market is going to cool off. Let us go back to our real estate example that we started in part 1 to explain how a Put options contract works.

Put Options and Real Estate

In the previous example we saw a real estate boom due to new businesses moving into your small hometown. You approached a homeowner and made an agreement (call options contract) that allowed you to purchase his home for $100,000 anytime over the next year. The contract cost you $5,000. Well, you did sell his home for $150,000 from the surge in real estate prices. You turned $5,000 into $50,000 in just a few months. But now you feel the market is overvalued and you wish to make money from a falling economy. How can you do so?

You have a rich uncle that is thinking of purchasing a vacation condominium in your area. There are many such structures being built all over the city, so availability will not be a problem. You decide to approach your uncle to find out the particulars.

"Nephew," your rich uncle states, "I would like you to find me a condominium. I have $200,000 to spend and I would like to vacation there next year." Your brain starts buzzing with ideas and how to profit from a real estate market you think is about to cool off. You had heard some of the businesses were pulling out, and the inflated prices along with manic buying should cool off.

"I'll make you an agreement," you propose. "Make out a check for $200,000 and give me a year to find you a condominium. If I can’t, you can stay with me next year."

"But I saw that many condominiums are currently available for that price range. Why do you need a year," your rich uncle asks.

"Because," you tell him honestly, "I think the market is going to cool off. If I can buy one of those condos in 8 months for $175,000, then I can pocket the $25,000 difference." At first your uncle frowns as he mulls this over, and then a big grin comes across his face.

"Okay," he states, "that sounds fair as I am willing to pay today’s market price for a condo. But you are speculating with my money, and that is going to cost you. I will draft up this agreement and you will pay $5,000 for the rights on such an agreement. I didn’t get rich for nothing you know."

Put Options and the Stock Market

The above example highlights how a Put options contract works. You become the middle man between a potential buyer and the market as opposed to a seller and the market with a Call options contract. Your Put options contract is with someone who agrees to buy an asset, real estate or stock, at a certain price (strike price). If the market cools off and the real estate or stock prices drop, you can buy at deflated prices. The difference between how much the buyer agreed to pay and current market prices is your profit.

If your Put options contract states the strike price, or the value the buyer will pay for the stock , to be current market value, then the contract is said to be ‘at the money’. In the above example, the rich uncle agrees to buy a condo for $200,000 which is current market price, so this contract is ‘at the money’.

If the Put options contract stipulates that the strike price is less than current market value, then the contract is said to be ‘out of the money’. This would be true if your uncle was only willing to pay $190,000 for a condo when the current price is $200,000. If the strike price were at $190,000, you would need to wait for prices to drop before you could even make a transaction at a breakeven point. Of course, the contract would be cheaper, perhaps only $1,000.

Put Options ExampleWhat if you wanted your uncle to agree to pay $220,000 for a condo that was only worth $200,000? In what circumstances would he agree to this? Only if you added $20,000 upfront to the contract in addition to what the agreement itself is worth. The $20,000 would be the intrinsic value added onto the contract worth which is extrinsic value. When the strike price is above the current market price on a Put options contract, we call this an ‘in the money’ contract.

Put and Call Options

To keep it simple, just remember that you buy Call options when you expect the market to rise, and Put options when you anticipate a market drop.

  • Purchasing Call options positions you as middle man between a seller and the market.
  • Purchasing Put options positions you as middle man between a buyer and the market.

The strike price is the agreed upon transaction price stipulated in the contract. You profit from the positive difference between the strike price and current market price of the asset. This difference is also the intrinsic value of the option. The cost of the agreement, or the total cost of the options contract minus the intrinsic value, is labeled the extrinsic value.

Now that we know what basic stock options are, it is time to learn why we should trade them.