What are Options?
What are Put Options?
Put Options give the option buyer/holder the right, but not the obligation, to sell shares of stock at the strike price during the term.
Put options make money when the stock falls below the strike price by an amount greater than the cost of the option.
The breakeven for a put option is the strike price minus the option price. Here is how it works. If you buy a put option on stock symbol ABC, let's say the stock is trading at $100 per share. You think the stock is going to move down, so you buy the 100 put option that expires in 1 months time. The option's ask price is $1.00. The option provides rights to sell 100 shares so you pay $1.00 for each share that the option controls. This makes your cost in real money $100.00.
For the cost of a single share, you obtain the right to profit on 100 shares if your right about the stock going down within the next month. Now let's examine the potential in three different scenarios.
Scenario 1. Breakeven
In this scenario, the stock moves down to trade at $99 per share. You paid $100 for the right to sell 100 shares at a price of $100 per share. You can exercise your right to sell the 100 shares at $100 each. This means you could buy the shares in the open market for $99 per share That would be a total of $9,900. You can then exercise your option to put those shares to the option seller for $100 per share and you collect $10,000. This results in a transaction profit of $100. Since you paid $100 for the put option, this trade would end as a wash and you would break even on the trade.
Scenario 2. Loss
In this scenario, you are dead wrong about the direction of the stock. ABC invented a very effective treatment for cancer. Overnight the stock doubles to $201. You are happy for the folks you have cancer, but you are not happy for your trade. You are happy that you bought the option instead of selling short the stock. You remember that you have the right and NOT the obligation to sell the shares at $100 per share. You decide to leave things alone and not to give the option seller shares at $100 and you say goodbye to your $100. The lucky shareholders win $10,100 and you are jealous but happy that their gain didn't come out of your wallet.
Scenario 3. Big Win
In this scenario, you were right on about the stock direction. The CEO of ABC is caught embezzling a fortune and overnight the stock is at 0. It's a big scandal. The shareholders are furious. But you are an option buyer. And you are extremely happy about that today. You go to the market and you find a shareholder willing to sell you 100 shares for $1.00 or a penny a share. You then decide to exercise your right to sell the shares at $100 per share. The option seller is not happy that you are putting 100 shares to them for $100 per share. But the contract requires them to fork over $10,000 for 100 worthless shares. You are thrilled to buy the shares for $1 and sell them for transactional profit of $9,999. You subtract the $100 you paid for the option and you just made $9,899 for a 989.9% gain on a $100 investment.