What are put options and how can they help your portfolio?

What are put options and how can they help your portfolio?

What are put options and how can they help your portfolio?

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Here’s what you need to know about put options.

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When it looks like the markets are about to crash, like recently, some investors are looking for short-term alternatives to stocks and other traditional long-term investments. Put options are one such option. Put options are a bet that an underlying security, such as a stock, will go down. Investors sometimes use put options to cushion losses when the market price of a security – such as a stock – falls. Investors also use put options to make a profit. They can be risky if the underlying stock goes up, you could lose money.

Before buying a put option, you may want to consider consultation with a financial advisor to review your portfolio and determine if this is the best financial option for you. There are several options available to you.

A financial advisor can review what exactly a put option is and how it works – but it never hurts to come prepared. Here’s a brief overview.

What is a put option?

A put option is a written contract to grant a buyer the right to sell shares of an underlying security (such as a stock) at a specified price during a specified period of time. This locks in at a predetermined value. The purchaser, or holder, is not obliged to sell the put option, but once the contract expires, it will have no value.

Put options can offer “defined risk” or limited risk to buyers because the holder will not lose more than the price paid (called a premium) if the contract expires without the option being exercised, traded, or sold.

How do put options work?

Stock options are sold as contracts. A single contract represents 100 shares of the underlying stock. For example, if a put option contract is quoted on an exchange at $3, the cost to buy the contract is $300, or 100 times the value of the option. This $3 is called the premium – the price paid for the right to sell the stock at a certain price within a certain period of time.

A financial advisor can help guide you through the process and explain in detail the benefits and risks that come with putting options. See if it makes sense for you to buy a put option or if you should abstain. The value of a put option increases when the price of its underlying stock falls. If the market price rises, the value of a put option falls and becomes worthless.

Imagine that the stock of company A is trading at $100 in June. When you buy a put option that expires in one month, you have the right to sell at a strike price of $100 during that period. Now imagine that company A’s stock drops to $80 at some point during the contract. Since your put is “in-the-money” or below the “strike price”, you can choose to “exercise” your put option at $100. The original writer or seller of the contract is obligated to sell the shares underlying assets to the put option contract holder for $100, even if their market value is $80.

Using the above example of a $3 put contract, selling the put means you would earn $20 per share ($100 minus $80 times 100 shares) or $2,000. If you subtract the $300 premium paid when you bought the put, you end up with $1,700 before expenses. If Company A’s stock does not go below $100, its put is “out of the money.”

If you already have a put contract, but you want to exit it before the expiration date, you can “close” your position by selling the same option contract you bought at a profit or loss.

When your put option contract expires, it is no longer valid. The seller of the put option keeps the premium you paid.

How to buy and sell put options

To buy and sell put options, you must open an account with an options broker. The broker assigns a trading level to your account. Be sure to carefully study how to fill out the forms, which can be tricky. Your account will also have a form for selling put options linked to the strike price.

A put option contract can help protect its buyer, or holder, against losses within a specified period of time should the price of the underlying stock fall.

Your put option can also be profitable, depending on the price of the underlying asset and the premium paid for the contract.

Alternatives to exercising put options

You can sell options contracts or trade them before the expiration date.

You can let the contract expire. You will not profit. In the example above, however, you may have spent $300 to protect yourself against potentially larger losses.

What happens when you exercise a put option

When the put option contract holder exercises the right to sell, the initial seller, or “writer”, receives an “assignment notice” that he must abide by the contract by buying the underlying asset at the strike price.

What is a call option?

A call option is basically the opposite of a put option. It is essentially a bet that the underlying security of the contract will increase. Buyers of call options can profit if the underlying asset exceeds the strike price, less the option contract premium paid.

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