What is a put option?
Investing in options can earn you a lot of money, but you need to know a few things about them before you can make a profit. Buying or selling a put option are some of the possibilities if you want to start trading in options. You can read what a put option is and how you can start trading put options in this article.
Put options guide: what do you want to know?
- Definition: what are put options?
- Trading options: how can you trade in put options?
- Strategy: what are put option strategies?
- Analysis: how do you analyse the underlying security?
- Advantages: what are advantages of put options?
- Disadvantages: what are disadvantages of put options?
Before we explain what a put option is, we should perhaps first explain briefly what an option is. When you start investing, you may be familiar with what a stock is, but it becomes more difficult to explain what an option is.
When you buy a share, you actually buy a piece of a company. You get a share with which you can prove that you are a co-owner.
When you buy an option, you do not buy a piece of a company. An option is a derivative that relates to an underlying security. This is often a share, but it can also be a derivative of an index, currency or commodity such as gold.
What makes an option different from a stock?
If you buy a Royal Dutch Shell stock, the price of that share can rise and fall, making your share more or less valuable. An option is called a derivative, because an option is based on the value of that underlying security.
To explain this, we return to the example of Shell. A Shell option is based on the value of the underlying Shell share. The price of the option is largely derived from the underlying product, but is also determined by the maturity and volatility of the price.
Types of options: what is a put option, and what is the difference with a call option?
An option gives you the right to buy or sell a predetermined quantity of shares at a specified price, also known as the strike price. Options also have an expiry date. This means that on the expiry date, you have to choose whether you want to exercise your right to buy or sell stocks.
You can buy an option with a duration of, for example, a week or a month. After you have bought an option, the expiry date and the exercise price cannot be changed. You buy an option to respond to an expected price increase or decrease. For this purpose, you can buy a call option or a put option.
What is a call option?
With a call option, you buy the right to buy shares. Let us use the example of Royal Dutch Shell again. Suppose you buy a call option Shell for $50. You then have the right to buy 100 shares of Shell within a period of one month for $10. If the price of a Shell share rises within that month from $10 to $12, you can therefore buy 100 shares at a profit of $2 per stock. After deducting the costs for buying the option, you will be left with a total profit of $150.
What is a put option?
With a put option, you buy the right to sell, which is actually the opposite of a call option. Let us return to the example of Royal Dutch Shell. Suppose you buy a put option Shell for $50. You then have the right to sell 100 shares of Shell within a month for $10.
You buy a put option because you think that the price of Shell shares will fall. If the price of a Shell share does indeed fall to $8, you can still sell your Shell shares for $10. In this example too, you have made a profit of $150 after deducting the costs you made to buy the option.
What is the difference between a European put option and a US put option?
Different rules apply to US options and European options. With American put options, you can exercise your right to sell during the entire term. But with European options, you can only exercise this right on the expiry date. You can remember this with a memory aid: The A of American stands for Always, and the E of European stands for End of Maturity.
However, although with an American put option, you have the right to sell earlier, in practice it does not happen very often that people exercise their right to buy or sell before the end of the term.
Just like a share, you can buy and sell a put option at a certain price. You can make a profit by trading in put options when the price of a share drops, because the value of your put option then rises. The difference between the price you paid when you bought the options and the price you sold them for is your profit.
A good party where you can buy and sell options is DEGIRO. DEGIRO is a reliable broker where you can get started against low fees. Use the button below to open an account at DEGIRO:
How can you make money buying put options?
With a put option, you buy the right to sell shares. You can do so for a fixed exercise price and before a certain expiry date. When the option period expires, you determine whether you want to exercise the right to sell. If the share price is lower than the exercise price, you would be wise to exercise your right to sell. You can then sell your shares at a higher price than the current trading value and make a profit.
How can you make money writing put options?
Two parties are involved in concluding a contract for an option: the buyer and the seller or writer. Instead of buying a put option, you can also write a put option.
In the case of a call option, the option gives you the right to buy, and you pay a premium for doing so. The writer, on the other hand, has the obligation under the contract to sell the option, but receives the premium for doing so.
With a put option, it works differently. If you have bought a put option, you have the right to sell, and you pay a premium for this. The writer then has the obligation to buy the shares but receives the premium.
The risks of writing put options
By writing put options yourself, you can make money on the premiums. But you can also lose large amounts of money if you do not handle it well. For example, it is wise when you write options to actually buy the share so that the options are covered.
If you do not do so, there is a chance that you will have to buy the shares at a higher price later on and that you will suffer great losses. This is called uncovered option writing. Because of the high risks involved, it is better to wait until you have more experience in buying options.
What is a margin requirement for writing options?
By writing an option, you create a short position. If you enter the position, you will receive money. But if the price is not moving in the right direction, it costs more money to close the position.
This is what the margin requirement is for. The margin requirement acts as a buffer by requiring you to have the same amount of money in your account as the option you want to write. If you do not have enough money in your account, your bank or broker can ask you by telephone or e-mail to deposit money to meet your margin requirement. This is called a margin call.
Sell put options with price gain
Another way to make money with put options is to sell the option with a price profit. If the price of the underlying security falls, the put option will only become more valuable. Instead of exercising your right and selling the shares, you can also choose to sell the options.
The advantage of selling your option with a price profit is that it is a lot easier than selling an option on a share. An additional advantage is that most brokers charge less transaction costs.
If you want to trade in options, you can use different strategies. We list the best-known put option strategies:
With the married put strategy, you buy a put option on shares you already own. In this way, you create an insurance against price falls, as it were, because with a put option you have the right to sell shares at the exercise price. With this strategy, you can therefore limit the risk of your shares.
Put credit spread
This strategy is called the put credit spread or the bull credit spread. You use this strategy if you expect the price of the underlying asset to rise. In this case you write an out-of-the-money put option (an option with a strike price above the current market price) and, at the same time, you buy a put option that is even more out-of-the-money.
You want the premium received for the written put option to be higher than the premium you pay for the option you buy, so you receive money at the start of this strategy.
You make a profit if the price rises, stays the same or does not fall further than the strike price of the written put.
The straddle is a strategy that you use if you suspect that something is going to increase the volatility of the underlying asset, but you do not yet know in which direction the price will move. This can be the case when a company is about to announce its results. In this strategy, you buy a call option and a put option with the same strike price and the same expiry date.
The exercise price of these options is as close as possible to the current market price (at-the-money). Because you buy both options and also have to pay an option premium for both, the price fall or rise must be greater than what you have paid in option premiums.
What does long and short mean when trading put options?
You have probably come across the terms long and short in relation to options trading. Let us first look at what these terms mean before we discuss how it works in relation to options trading.
In stock trading, a long position means that an investor owns the shares and responds to a price increase. Short selling means that the investor sells shares he does not own, with the aim of buying them back at a later date at a lower price.
You basically borrow the shares to sell them, and therefore hope to buy them back at a lower price, because then you make a profit. The profit that the investor makes is the difference between the selling price and the lower purchase price of the share. With a long position, you make a profit if the share rises, and with a short position, you make a profit if the share falls.
Long put option and short put option
When writing options, going long and short have an extra dimension. With a long call, you buy the call option and profit from an increase in the price of the underlying asset. With a long put, you buy a put option and you make a profit if the price of the underlying asset falls.
A short call is exactly the opposite of a long call. With a short call, you sell the option and make a profit when the value of the call or the underlying asset decreases. With a short put, you sell the option and make a profit if the underlying asset is higher than the strike price of the option.
What is the difference between options and CFDs?
With an option, you as a buyer have the right but not the obligation to buy or sell a share at a predetermined price within a certain period. If the share price at the end of the period on the expiry date does not meet the Exercise Price, the option no longer has any value.
A Contract for Difference or CFD is broadly similar to a traditional option, but there are some important differences. When trading CFDs you can speculate on the future price or strike price of, for example, a share, index or commodity, without having to buy the underlying asset. After the expiry date the difference between the opening and closing price is immediately settled with your balance, whereas with traditional options, you do not have the obligation but the right to buy or sell.
Trading options with a broker
Options trading is quite complex, and requires you to be involved in investing at least on a daily basis to be able to predict the prices as accurately as possible. You can also call in the help of an investment specialist or a broker such as DEGIRO. The big advantage of this broker is that it is a reliable party where you can trade in options against low fees. Click here to go to DEGIRO:
If you want to trade options successfully, you must learn to analyse the market and try to predict what the price of a stock will do in the short term. This sounds easier than it is. Prices can be very volatile, which can make it difficult to make a prediction.
Analysing the market for trading put options
If you want to trade put options, and you want to predict what the price of a stock is going to do, you can use two techniques: A Fundamental Analysis (FA) and Technical Analysis (TA). Both techniques complement each other and are therefore often applied together.
Fundamental Analysis (FA)
With fundamental analysis (FA), you determine the value of a stock by using economic and financial factors. By applying an FA, you can discover whether the current valuation of that share is overvalued or undervalued. For this purpose, you analyse the value of a company on the basis of turnover, profit, debts that you obtain from annual accounts and quarterly figures.
Technical analysis (or TA)
With technical analysis (TA), you try to predict the future price movements of a share on the basis of its past prices. You can look for patterns in trend lines, candlesticks and graphs.
The advantage of buying options compared to buying shares, is that options are much cheaper. When you buy an option, you do not buy a share in the company, but a derived product. That makes options more attractive for small investors.
Another big advantage is that trading options allows you to achieve high returns within a short period of time. More experienced investors can also use a leverage effect with options. This allows you to invest large amounts with a relatively small investment, because the person who sells you the options with leverage actually lends you the money.
Another advantage is that you can protect your shares from falling in value by buying a put option on the shares. If the shares fall in value, you can still sell your shares at a reasonable price.
Trading options is more complex than making a long-term investment. This means that you need to gain some experience before you can make high returns. It also takes a lot of time to keep track of the market and execute analysis.
The biggest disadvantage is that you can lose your entire investment with options. If you do not manage to sell your option at a profit before the expiry date, it will not be worth anything after that date.
If you are going to write put options, there is a chance that when the price falls, you will be asked to buy while you expected the price to remain the same or even rise. When the exercise price is higher than the share price, you will have to pay more, which means you will lose money.
Where can you trade put options?
You can trade put options by placing an order with a broker. A broker provides you access to the financial markets. As a private individual, you can buy and sell put options at a broker such as DEGIRO.
Click here to go to DEGIRO & open an option investing account directly:
Plus500 is a good broker for trading CFD options. If you are just starting out, you can get unlimited practice with a risk-free demo, and has the big advantage that the website and the help desk are in English. At Plus500, you can only trade CFDs, not traditional options.
Click here to go to Plus500: