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Put Options: A Deeper Dive

Put Options: A Deeper Dive

Like calls, put options are a type of options contract. The difference is that they give an investor the right to sell a security for a specified price within a given period of time. Option expiration dates can range from a few days out to several years. Options that expire a year or more from their listing date are typically known as LEAPS (Long-Term Equity Anticipation Securities).

One of the earliest references to options trading was seen in the book, Politics, written by Aristotle in the mid fourth century. The book included how Thales of Miletus earned massive profits from an olive harvest.

According to the story, Thales forecast the next olive harvest would be an exceptionally good one. As nobody knew for certain whether the harvest would be good or bad, he secured the rights to the presses at a relatively low rate. When the harvest proved to be bountiful, and so demand for the presses was high, Thales charged a high price for their use and reaped a considerable profit.

Option contracts may be out of the money (OTM), at the money (ATM), or in the money (ITM). When a put contract is OTM, the option is not profitable because the strike price is below the current market price. A put contract is ATM if the strike price equals the market price. Put buyers want their options to be ITM with the strike price above the market price.

As an example, assume that put options with a strike price of $20 are trading for $2 each and expire in six months. Buying one contract (100 shares) costs $200. By purchasing a contract, you have the right to sell 100 shares of Company ABC for $20 per share any time over the next six months.

If you're correct and the stock drops to $15 by the expiration date, your put options are worth $5 per share, giving you the right to sell the $15 stock for $20. After subtracting the cost of each option ($2), your total profit on one option contract would be $300.

The Options Clearing Corporation (OCC) was founded in 1973 to ensure that the obligations associated with options contracts are fulfilled in a timely and reliable manner. Most of the option trading prior to that time had been done by farmers and businesses seeking to hedge their agricultural exposure.

Both call and put options can expire worthless because the security doesn't reach the breakeven point. In that case, you lose the amount you paid for the premium. Selling calls and puts is much riskier than buying them because it carries greater potential losses. If the stock price passes the breakeven point and the buyer executes the option, then you're responsible for fulfilling the contract.

For options trading, you need to predict three things correctly:

  • The direction the stock will move.
  • The amount the stock will move.
  • The time period of the stock movement.

To summarize, call options are contracts that say investors can buy a stock for a specific price, while put options say that investors can sell a stock for a specific price outlined in the contract before the option expires.