A put option gives you the right to sell for the duration of the option a specific number of stocks at a price you stipulate when paying the option premium. One frequent use is to place a put on a stock you hold and want to keep in your portfolio, but that you fear may suffer a near-term price drop. Puts limit losses if the share price drops, but also reduce potential profits.
Getting Started with Put Options
Talk with your broker or online brokerage to determine if you are now qualified for options trading. If not, fill out and return an options upgrade application.
Determine what you want the put option to accomplish. For example, suppose you want to protect against losses in 1,000 shares of Widget Corp. that you now own. The stock is now at $45 per share. You believe that over the next five months the stock could decline by as much as 8 percent, but probably not more. You are willing to spend up to 3 percent of the stock's current value to protect yourself against that possibility. Calculate the cost of that protection by multiplying $45,000 -- the current value of your Widget shares -- by 3 percent. This equals $1,350.
Consult a broker to determine if an available put option accomplishes your goal at a premium cost you are willing to pay. Alternatively, use a Black-Scholes calculator to determine the cost. Note that when market volatility is high, the premium price rises. The longer the duration of the put, the greater the premium. Also, the higher the strike price -- the share price you receive when you close out the position -- the higher the premium cost. The other factor included in the Black-Scholes calculation is the risk-free return rate. This is the rate an investor pays in the current marketplace for an investment with zero risk. The usual approximation of this rate is the current rate on a 90-day U. S. Treasury Bill. Put option prices decrease as this rate rises. Entering different values into a Black-Scholes calculator will give you a better understanding of how these factors enter into the premium price of your put.
Tell your broker to place the put, or place it online yourself, once you are satisfied that an available put option meets your criteria.
- Stock Options Handbook for Beginners; Walter Street
- Hedging Market Exposures: Identifying and Managing Market Risks; Oleg V. Bychuk and Brian Haughey
- In many cases, a good strategy for using put options is to consider them as a means of reducing volatility, rather than as a way of avoiding losses entirely. Cost effective puts limit potential profits and potential losses.
- Investors new to the options market will benefit from a consultation with a professional advisor. Commissions for put options vary widely from one full-service brokerage to another. Before buying a put you understand the full cost.
Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.