In this guide to understanding Put Options, we’ll describe what they are, give examples of situations in which they might be a viable option, show how they are different from shorting strategies, and discuss the strengths and weaknesses of these strategies.
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What Are Put Options?
Buying put options is a bearish strategy using leverage. It is a risk-defined alternative to shorting stock.
Example: Bearish and Risk-Averse
An example of the thought process of buying a put goes like this:
- A trader is very bearish on a particular stock trading at $50.
- The trader is either risk-averse. They want to know beforehand their maximum loss or they wants greater leverage than simply shorting stock.
- The trader expects the stock to move below $47.06 in the next 30 days.
Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44.
For this example, the trader will buy only 1 put option contract. (Note: One contract is for 100 shares.) The total cost will be $0.44 x 100 shares = $44.
Chart 1 below illustrates this example with a hypothetical stock:
Why Might a Trader Consider Put Options?
There are numerous reasons, both technical and fundamental, for why a trader could feel bearish:
- Options offer defined risk.
- Options offer leverage.
Let’s look at each of these reasons in more detail.
Options Offer Defined Risk
When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in the example from Chart 1 that amount is $44.
Even if the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid to purchase the option.
This is the risk-defined benefit often discussed as a reason to trade options.
Options Offer Leverage
Another benefit of options is leverage. When a stock price is below its breakeven point, the option contract at expiration acts exactly like being short stock.
In the Chart 1 example above, the breakeven point is $47.06.
To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100).
Likewise, below $47.06 (the options breakeven point), if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.
On the other hand, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500).
However, the trader in this example, only paid $60 for the put option and doesn’t need to worry about margin calls or the unlimited risk to the upside.
Options Require Timing
The important part about selecting an option and option strike price, is the trader’s exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish.
Why foolish? Because at expiration, if the stock price is above $47.50 by any amount, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.
Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option.
Put Options vs Shorting
When buying options, a trader needs to predict:
- The correct direction of stock movement,
- The correct size of the stock movement, and
- The time period for when the stock movement will occur.
These factors make put options more complicated than shorting stock, since shorting only requires predicting that the stock price will move downward.
Put Options Outcomes
Chart 2 below is the profit/loss graph at expiration for the put option in the example given in Chart 1.
Let’s go through the possibilities involved with this strategy:
- A trader may break even,
- They may profit,
- They may partially lose,
- They may completely lose.
The breakeven point is quite easy to calculate for a put option:
- Breakeven Stock Price = Put Option Strike Price – Premium Paid
To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 – $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.
To calculate profits or losses on a put option use the following simple formula:
- Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration
For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract.
So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price – $45.00 stock price at expiration).
In total, the trader would have made $206 ($2.06 x 100 shares/contract).
Outcome: Partial Loss
If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money.
For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price – $47.25 stock price).
Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).
By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.
In this partial loss example, the option trader bought a put option because they thought that the stock was going to fall.
Outcome: Complete Loss
If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44.
Likewise, if the stock moved up, regardless of how much it moved upward, then the option trader would still lose the $0.44 paid for the option.
In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).
Again, this situation is where the limited risk part of option buying comes in: The stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.
Downside of Buying Put Options
Take another look at the put option profit/loss in Chart 3 below. This time, think about the gap between the current stock price of $50 the breakeven price of $47.06 is.
Put Options Need Big Moves to Be Profitable
Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days.
Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade.
Scenarios: Put Options vs Shorting
Here’s a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price):
- 100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
- 1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.
|Stock Down 2%||Gains $100 (1.3%)||Loses $44 (0.6%)|
|Stock Down 5%||Gains $250 (3.3%)||Loses $44 (0.6%)|
|Stock Down 8%||Gains $400 (5.3%)||Gains $106 (1.4%)|
It’s fair to say, that buying these out-of-the-money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader’s call options will expire worthless.
However, the benefit of buying put options to preserve capital does have merit.
Put Options Upside: Capital Preservation
Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to break even.
Also, it is important to emphasize that shorting stock is very risky since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.
Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade.
This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading.
For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:
- Shortseller: Loses $250 or 3.3%
- Option Holder: Loses $44 or 0.6%
For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:
- Shortseller: Loses $1,000 or 13.3%
- Option Holder: Loses $44 or 0.6%
In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.
Summary: Options Considerations
Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances.
Options require a trader to take into consideration:
- The direction the stock will move
- How much the stock will move
- The time frame the stock will make its move.
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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74%-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
Learn more about technical analysis indicators, concepts, and strategies including:
- Bull Call Spread – A risk defined and reward defined alternative to buying call options.
- Bear Put Spread – A cheaper alternative to buying put options outright, however, defines max reward.
- Read our guide to choosing an options brokerage service.