If you think a stock's going to go down in value -- and you're right -- buying a put option is a good way to turn a profit. A put option gives you the right, but not the obligation, to sell or "put" a specific stock to another investor within a certain time period. As a leveraged bet against a stock, a put option can move up greatly in value if the underlying stock falls. However, the opposite is also true -- if your bet is wrong, you could lose your entire investment.
Terminology
While you can buy many different kinds of stock options, they all share the same basic terminology, which makes it much easier to understand an otherwise complicated subject. Each option controls 100 shares of underlying stock and is quoted in the format "name, month, price." The name of the underlying stock comes first, followed by the month of expiration and the strike price. The expiration month shows you when your option expires, or ceases to exist, while the strike price represents the price at which you can sell your stock to another investor. If you buy an IBM October 50 put, for example, you now have the right to sell 100 shares of IBM stock at $50 per share by the October expiration.
Intrinsic Value
Options can be confusing for investors because they don't really carry any value of their own. Options are known as "derivatives" because they derive their value from another investment, such as a stock. One of the two variables that give a put option value is referred to as its intrinsic value. A put option's intrinsic value is the dollar amount by which the stock is "in-the-money," or below the put option's strike price. For example, if you own an IBM October 50 put, the option has an intrinsic value of $4 per share if IBM stock is currently trading at $46 per share. If the price of IBM drops to $40 per share, then the option would have an intrinsic value of $10 per share, as it is $10 below the $50 strike price of the put. The more the stock drops in price, the more money you can make on a put option since its intrinsic value will keep going up.
Time Value
You can't buy an option certificate and put it away in your safe, hoping it appreciates in value like a stock certificate or the title to a home. In fact, the longer you hold your option, the more it loses time value, which is the second component to option valuation. An option's time value is the amount of the option's market price that exceeds its intrinsic value. For example, if you own an IBM October 50 put and IBM trades at $40, the intrinsic value is $10. However, if it is only June, the market might value that option at $15. The $5 value above the $10 intrinsic value is the time value. Options have more time value the farther away the expiration date is, as it affords the option holder more time to cash in on a movement in the underlying stock price. If it is only June and you own an October put, you have four months in which the stock price might fall and generate a profit for you. This time period has value, and it is reflected in the time value of the option.
Exercise
You can sell your put option on the open market anytime you are happy with your profit, or perhaps to avoid further losses. However, you can also exercise the option anytime before the expiration date on the contract. Exercising the option means that you are selling the stock to an investor at the specified price.
Expiration
Put options expire at the close of business on the third Friday of the option month. For example, an IBM October 50 put expires on the third Friday of October. If the option has no intrinsic value at that time, your option will expire worthless, since the time value will have ticked down to zero. If IBM trades above $50 per share on the third Friday in October, your IBM October 50 put will expire worthless.
References
Writer Bio
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.