If you have found yourself here, you likely have a basic understanding of options and can easily define strike price, option price (exercise price), and expiration date. If those words are completely foreign to you I HIGHLY recommend reading the short article linked below which is an overview of options so that this article will make more since.
Moving on, if you already have a basic understanding of options and are just trying to figure out what the heck the difference is in all of them, this article is for you! Specifically, we will be reviewing put options, and explaining how you can make (or lose) money in three different market scenarios- the stock price goes up, the stock price goes down, or the stock price stays the same.
In a previous article, I explained that you can make money with options when the price goes up, down, or stays the same and selling puts is a basic example of this concept.
First- What Is A Put Option?
Feel free to skip this section if you already know the answer to the question above. BUT, if you do not know or would like a short review– a put option gives the owner of the contract the right to SELL 100 shares of stock. So what happens when you sell a put contract? You give someone else the right to sell you 100 shares of stock. If the exercise their right to sell the shares, you have the obligation to buy them.
Let’s do an example: If you sell a put contract for $10, at a $500 strike price for stock XYZ, expiring in 21 days what does this mean?
This means that you are receiving $10 from someone in the market. Said person is paying you in order to lock in a stock price for XYZ of $500 to sell back to you within 21 days.
** Remember that option prices are denominated by 100, given the underlying 100 shares of stock- in simpler terms, this option/exercise price is actually $1000, not $10. And the stock is actually worth $50,000 not $500. $10, and $50 is going to be the amount you see when placing your trade.
THAT WAS CONFUSING so let’s look at the contract in a different light. Now I honestly can not think of a deal like this ever taking place, but IMAGINE you are a buyer who is optimistic of market conditions. Your supplier, on the other hand is skeptical and believes that the market may crash. Given your different view points, you decide to propose a deal with your supplier which will give them the right to sell you 100 units of product XYZ for a fixed price of $500 per unit (or $50,000). This deal will cost the supplier $1000. Now, if the supplier chooses to sell, you are obligated to buy all 100 units of product XYZ. Key difference here- the buyer of the contract has a choice, you as the seller has an obligation. So how do you make money by selling put contracts? Read below for the three scenarios.
1. The stock price goes above your strike price
Review from our above example that we are selling a put option for $10, which gives us the obligation to buy back 100 shares of stock at a predetermined strike price of $500 within 21 days time. The stock price going above $500 is our ideal scenario.
Explained here: If someone has the right to sell you something for $500, but they can instead sell it in the market for $600, why in the world would they want to sell it to you? This is an easy deal. You sold your contract for a total price of $1000, and $1000 is your profit assuming you hold your option until expiration (the full 21 days). Don’t get too excited, options are usually never held until expiration, but 30-50% of this max profit is a reasonable goal.
Main point: If the stock price goes above your strike price by ANY amount you will make money.
2. The stock price goes below your strike price
As you have likely guessed, this is not your ideal scenario. In most cases if the stock price goes below your strike price you will lose.
Now, if the stock price dropped from $500 to $0 the owner of the put option is obviously going to choose to sell the stock to you for $500 instead of to the market for $0. Unfortunately for you, this would be a $49,000 loss. Fortunately for you, the stock price will absolutely never drop to $0.
If you are curious how this max loss is calculated:
(strike price*100 shares)- option price
(500*100) – 1000
=$49,000
This is the absolute worst case scenario, and will only happen if you invest in things like GameStop.
BUT- you can still win if the stock price goes below your strike price. Now imagine the stock price only goes down to $495. Here you are losing $5 per share or $500. But remember that $1000 you received for selling the option? Here, even though the price dropped, assuming you hold this option until expiration, you are still profiting $500.
Main point: If the stock price falls below your strike price, you will lose money. BUT, the stock price has to fall by an amount MORE than what you sold the option for.
3. The stock price stays the same as your strike price
At first glance, in this scenario you may guess that you will break even here. Not the case. From the above scenario, you may remember how the option price (or exercise price) played a role in giving us more room for profit. The same holds true here. We received $1000 for selling this option, and because the market price and the stock price are the same, this option holds no value to our buyer. In other words, if held until expiration we would receive a max profit of $1000.
Main point: If the stock price stays the same as your strike price you make money.
Summary
With all the numbers, this article is easy to get lost in, but you should leave this page understanding a few key concepts.
FIRST- know what a put is, and know the difference between a put and a call.
A put is an option to sell. A call to buy.
Next- know what it means to sell a put.
If you sell a put option, you are selling someone else the right to sell you 100 shares of stock for a predetermined strike price, at a predetermined time. You collect a premium to get into the trade, and you buy back the shares to get out of it.
Lastly: How do you make (or lose) money?
- You MAKE money when the stock price goes above the strike price by ANY amount.
- You LOSE money when the stock price goes below your strike price by more than the amount you received for the option.
- You MAKE money when the stock price stays the same as your strike price
The ability to make money if the price goes up, down a little, or stays the same is the reason I personally choose to sell options as opposed to buying them. With that being said, if you have any questions, please leave them in the comment section below!