Put options are a type of option that increases in value as a stock falls. A put allows the owner to lock in a predetermined price to sell a specific stock, while put sellers agree to buy the stock at that price. The appeal of puts is that they can appreciate quickly on a small move in the stock price, and that feature makes them a favorite for traders who are looking to make big gains quickly.

The other major kind of option is the call option. It’s the more well-known type of option, and its price appreciates as the stock goes up. (Here’s what you need to know about call options.)

What is a put option?

A put option gives you the right, but not the obligation, to sell a stock at a specific price (known as the strike price) by a specific time – at the option’s expiration. For this right, the put buyer pays the seller a sum of money called a premium. Unlike stocks, which can exist indefinitely, an option ceases to exist at expiration and then is settled, with some value remaining or with the option expiring completely worthless.

The major elements of a put option are the following:

• Strike price: The price at which you can sell the underlying stock
• Premium: The price of the option, for either buyer or seller
• Expiration: When the option expires and is settled

One option is called a contract, and each contract represents 100 shares of the underlying stock. Contracts are priced in terms of the value per share, rather than the total value of the contract. For instance, the exchange prices an option at $1.50, but the cost to buy the contract is $150, or (100 shares * 1 contract * $1.50).

How does a put option work?

Put options are “in the money” when the stock price is below the strike price at expiration. The put owner may exercise the option, selling the stock at the strike price. Or the owner can sell the put option to another buyer prior to expiration at fair market value.

A put owner profits when the premium paid is lower than the difference between the strike price and stock price at option expiration. Imagine a trader purchased a put option for a premium of $0.80 with a strike price of $30 and the stock is $25 at expiration. The option is worth $5 and the trader has made a profit of $4.20.

If the stock price is at or above the strike price at expiration, the put is “out of the money” and expires worthless. The put seller keeps any premium received for the option.

How to buy and sell put options

Buying or selling a put option requires an investor to correctly input exactly the option they want, including many variables. There are literally dozens of different choices for any option security, and you need to know which one you want to buy or sell. Here are the key elements of an option trade that you’ll need to set up:

• Underlying security: The stock associated with the option
• Option strategy: A put or a call (or even more exotic things)
• Expiration date: The date at which the option is settled
• Strike price: The price at which the option holder is entitled to buy or sell the stock
• Premium: The cost of the option
• Order type: Market order or limit order

Be especially careful as you enter your trade because it’s easy to enter an order that’s exactly the opposite of what you intend to do, potentially costing you a lot of money. It’s one of the biggest mistakes you can make trading options.

As you’re placing your trade, you’ll also want to consider the breakeven price for your trade, that is, what price does the stock need to reach before you make money on the option at expiration.

Limit orders are also a must with options trades, so that you avoid running up your costs. With a limit order you specify the price you’re willing to accept for a trade, and if the market can’t meet your price, your trade won’t execute.

If you’re going to trade a lot of options, it makes sense to find the best options broker for you.

Advantages of buying put options

Traders buy a put option to magnify the profit from a stock’s decline. For a small upfront cost, a trader can profit from stock prices below the strike price until the option expires. When buying a put, you usually expect the stock price to fall before the option expires. It can be useful to think of buying puts as a form of insurance against a stock decline. If it does fall below the strike price, you’ll earn money from the “insurance.”

Imagine that a stock named WXY is trading at $40 per share. You can buy a put on the stock with a $40 strike price for $3 with an expiration in six months. One contract costs $300, or (100 shares * 1 contract * $3).

Here’s a graph of the buyer’s profit when the option expires assuming various stock prices.

As you can see, below the strike price the option increases in value by $100 for every $1 move in the stock price. As the stock moves from $36 to $35 – a decline of just 2.8 percent – the option increases in value from $400 to $500, or 25 percent.

The option may be in the money – below the strike price – at expiration, but that doesn’t mean the buyer has made a profit. Here the premium was $3 per share, so the put buyer doesn’t start earning a profit until the stock reaches $37, at the $40 strike price minus the $3 premium. So in this example, $37 is the breakeven point on the trade.

If the stock finishes between $37 and $40 per share at expiration, the put option will have some value left on it, but the trader will lose money overall. And above $40 per share, the put expires worthless and the buyer loses the entire investment.

Buying puts is appealing to traders who expect a stock to decline, and puts magnify that decline even further. So for the same initial investment, a trader can actually earn much more money than short-selling a stock, another technique for making money on a stock’s decline. For example, with the same initial $300, a trader could short 10 shares of the stock or buy one put.

If the stock finishes at $35, then…

• The short-seller makes a profit of $50, or ($5 decline * 10 shares).
• The options trader makes a profit of $200, or the $500 option value (100 shares * 1 contract * $5 decline) minus the $300 premium paid for the put.

This ability to magnify potential gains makes put options more attractive to some traders than investing in stocks.

Why sell a put option?

If you’re looking to trade options, you can sell them as well as buy them. The payoff for put sellers is exactly the reverse of those for buyers. Sellers expect the stock to stay flat or rise above the strike price, making the put worthless.

Using the same example as before, imagine that stock WXY is trading at $40 per share. You can sell a put on the stock with a $40 strike price for $3 with an expiration in six months. One contract gives you $300, or (100 shares * 1 contract * $3).

Here’s the seller’s profit at expiration.

As you can see, the profit for the put seller is exactly the inverse of that for the put buyer.

• For a stock price above $40 per share, the option expires worthless and the put seller keeps the full value of the premium, $300.
• Between $37 and $40, the put is in the money and the put seller earns some of the premium, but not the full amount.
• Below $37, the put seller begins to lose money beyond the $300 premium received.

The appeal of selling puts is that you receive cash upfront and may not ever have to buy the stock at the strike price. If the stock rises above the strike by expiration, you’ll make money. But you won’t be able to multiply your money as you would by buying puts. As a put seller, your gain is capped at the premium you receive upfront.

Selling a put seems like a low-risk proposition – and it often is – but if the stock really plummets, then you’ll be on the hook to buy it at the much higher strike price. And you’ll need the money in your brokerage account to do that. Typically investors keep enough cash, or at least enough margin capacity, in their account to cover the cost of stock, if the stock is put to them. If the stock falls far enough in value you will receive a margin call, requiring you to put more cash in your account.

For example, if the stock fell from $40 to $20, a put seller would have a net loss of $1,700, or the $2,000 value of the option minus the $300 premium received. If the option is exercised on you, you’ll be forced to buy 100 shares of the stock at $40 per share, while the stock is trading in the market at $20 per share. You’ll incur an immediate $20 per share loss on the stock, though of course that’s offset by the $300 you received for selling the put option.

But done prudently, selling puts can be an effective strategy to generate cash, especially on stocks that you wouldn’t mind owning if they fell.

Put options vs. call options

The other major kind of option is called a call option, and its value increases as the stock price rises. So traders can wager on a stock’s rise by buying call options. In this sense, calls act the opposite of put options, though they have similar risks and rewards:

• Like buying a put option, buying a call option allows you the opportunity to earn back many times your investment.
• Like buying a put option, the risk of buying a call option is that you could lose all your investment if the call expires worthless.
• Like selling a put option, selling a call option earns a premium, but then the seller takes on all the risks if the stock moves in an unfavorable direction.
• Unlike selling a put option, selling a call option exposes you to uncapped losses (since a stock can rise to any price but cannot fall below $0). Either way, you could lose many times more money than the premium received.

Bottom line

Many people think options are highly risky, and they can be, if they’re used incorrectly. But investors can also use options in a way that limits their risk while still allowing for profit on the rise or fall of a stock.