It’s strange but true: many investors who are perfectly comfortable trading call options get a little squeamish around put options. Puts are certainly nothing to be afraid of. When used properly, they can add a whole new dimension to your trading.
What are puts, exactly?
Put options are basically the reverse of calls: a call gives the owner the right to buy stock at a given price (the strike) for a certain period of time. A put, on the other hand, gives the owner the right to sell stock at the strike price for a limited time. Let’s discuss owning puts first, followed by holding a short put position.
If you own a put on stock XYZ, you have the right to sell XYZ at the strike price until the put option expires. Your maximum possible profit is obtained if the stock declines all the way to zero. The math for determining the profit is equal to the strike price less the premium paid for the put. (Don’t forget to factor commissions and taxes in there, too.) On the other hand, the maximum potential risk is losing the entire premium paid to purchase the option. This happens if the stock is at or above the strike price at expiration.
If you short a put on stock XYZ, it means you’d be obligated to buy XYZ from the put holder at that strike price if the holder exercises before expiration. In return, you’d earn a premium in exchange for taking on that potential obligation, and the premium received would be the maximum potential profit for this trade. This would occur if the stock is at the strike price or higher. However, you would hit the maximum potential risk if the stock fell to zero. The loss incurred would be equal to the strike price (at which you’d be obligated to buy the security) less the premium you received. Again, these calculations don’t factor in commissions or taxes, but in real-world trades you need to consider both of those.