People usually buy puts for one of three reasons:
- To protect shares you already own. A put can set a floor under the price you could sell at, a bit like insurance on your shares.
- To take a view on a stock going down. A $200 put can give you exposure to a fall in 100 shares, without selling shares you don't own.
- To cap the downside on that view. The loss is limited to the premium, however far the shares rise.
What is a put?
A put option gives you the right, but not the obligation, to sell a share at a fixed price (strike price) on or before a set date (expiration date).
For this right, you pay a fee, called the premium.
Each contract has a multiplier, usually 100, meaning it represents 100 shares. The premium is quoted per share, so a $2 premium costs $200.
If the share price is above the strike price at the expiration date, the option will expire worthless and you will lose the entire premium.
As the share price moves up and down, the value of the option will change. You are not required to hold the option until expiration and can sell beforehand.
A put is the mirror image of a call. A call gains value as the share price rises; a put gains value as the share price falls.
Key terms
Think of it like insurance on your car
Say your car is worth £10,000. You pay a £300 premium for a year of cover that will pay out its value if it's written off.
- If the car is written off during that year, the cover pays out and protects you from the full loss.
- If nothing happens, the cover runs out and you lose the £300, and nothing more.
A put option works in much the same way. The protected value is the strike price, the cost of cover is the premium, and the year is the expiration date.
A worked example
This example is hypothetical. It uses a made-up company and ignores fees, commissions and currency costs.
Shares in Example Co trade at $50. You think the price might fall over the next three months, so you buy one put option:
- Strike price: $45
- Expiration date: three months away
- Premium: $2 per share
One contract usually covers 100 shares, so the put costs you $2 × 100 = $200.
To make your money back, the share price has to fall below the strike price by at least the premium you paid: $45 − $2 = $43. This is known as the breakeven.
Here's what the trade looks like at the expiration date for a range of share prices:
If the shares end above $45, however far above, the most you lose is the $200.
What you can lose
When you buy a put, the most you can lose is the premium you paid.
- You can lose 100% of what you put in. If the share price doesn't fall below the strike by the expiration date, the put expires worthless.
- Being right isn't always enough. In the example, the shares fell from $50 to $46 and you still lost the full $200 as the share price is still above the strike price. Importantly, the share price has to move far enough, and soon enough.
- Time works against you. An option loses value as the expiration date gets closer, even when the share price stays flat. This is called time decay.
- Leverage goes both ways. A small move in the share price can mean a large percentage gain or loss on the option.
Selling (or "writing") puts is a different matter and carries larger risks. We cover it separately.
What's next
You've now seen both sides: a call is the right to buy, and a put is the right to sell. Next, we compare options with simply owning shares.