Put Options Explained: 4 Types of Put Option Strategies

A put option is a derivative investment that gives the option buyer the right to sell a fixed quantity of shares of an underlying security at a set price before the put option contract expires. If the buyer chooses to sell the shares, they do so at the predetermined price in the contract. Investors can buy or sell put options on numerous types of securities, such as stocks, bonds, ETFs, indexes, commodities, currencies, or a combination of several financial instruments. To invest in an option contract, the holder must have a brokerage account with a brokerage firm.

There are a few key elements to consider when learning about how put options work:

• Writer and holder: Put option contracts involve two parties: the writer and the holder. The writer (aka the seller) sells the contract to the holder for an upfront fee called the option premium. The contract obligates the writer to purchase shares from the holder (aka the buyer) in the underlying asset at an agreed-upon price within a specific amount of time—if the holder chooses to sell. The predetermined price is called the strike price. Even if the buyer doesn't exercise their option to sell by the contract's expiration date, the contract writer still keeps the option premium fee. A put option’s price fluctuates depending on the strike price, the cost of the underlying asset, interest rates, market volatility, and time decay.
• Short position: When an investor buys a put option, they're betting that the underlying asset price will be lower than the strike price when the put option contract expires. Since a put option increases in value when the underlying asset's price declines, the buyer is taking a short position on the asset—though put options are not the same as short selling.
• Time value: Another critical factor impacting the price of the option is time value. A put option is more valuable when there's a long period until it expires since there's more profit potential on the investment. As the expiration date gets closer, the put option experiences time decay and decreases in value. Once the expiration date arrives, the put option no longer has any time value, and all that remains is its intrinsic value—aka the difference between the strike price and the current market price. If the option's intrinsic value is positive, the buyer will typically exercise their option to sell because they can profit.

There are several common trading strategies when it comes to put options:

1. 1. Long put: This is the most common put option strategy and involves the investor taking on the role of the option contract holder (aka the buyer). In a long put, the investor bets that the underlying stock or asset price will decrease.
2. 2. Short put: In a short put—also called a naked put—the investor takes on the role of the option contract writer (aka the seller). In a short put, the investor bets that the underlying stock or asset price will increase. Investors who use this strategy aim to profit off the option premium fee that the buyer pays them at the contract’s start. Short puts can be risky since the investor is potentially obligated to buy worthless shares in the underlying asset if the market price of the shares plummets drastically.
3. 3. Protective put: Protective put options are essentially an insurance strategy investors can use when taking a long position on a regular stock market trade. For example, if an investor purchases stock shares, they're hoping the stock price increases, but they could also buy a protective put so that if the stock price decreases below the put option's strike price, they still profit on the put option. If the stock price increases above the strike price, they profit off the stock trade and only lose the cost of their option premium on the protective put.
4. 4. Bear put spread: Also known as a debit put spread, this is a strategy for options investors who want to decrease the cost of holding an options contract using a short put option to fund a long put option. In a bear put spread, the investor simultaneously buys and sells a put option contract with the same expiration date on the same underlying asset but with different strike prices. This strategy reduces the trade risk and limits profits to the difference between strike prices.

A put option gives the investor the right to sell shares in an underlying security within a particular time frame and at a specified price. A call option provides the investor with the right to buy shares in the underlying security. Unlike a standard put option, a call option turns a profit when shares of the underlying security increase in price because then the investor can buy the shares at a lower price than the current market price.

Put options and short selling are both investments that bet on the value of a security decreasing, but there are two key differences investments:

1. 1. Premium fee: With put options, the option buyer pays a premium fee to the contract writer for the right, but not an obligation, to sell a fixed quantity of shares in an underlying security at a predetermined price before the put option contract expires. In short selling, the investor borrows a security from a brokerage, sells it on the open market, repurchases the security, and returns the borrowed shares to the brokerage.
2. 2. Risk: The risk involved with a basic put option is less than the risk involved in short selling. The maximum loss for a put option investor is the option premium price, but an investor could sustain unlimited losses with short selling.

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