Long Put option
 

A put option works much in the same way as a call option, the difference is that investors who use put options look for opportunities to make money on the instrument which falls in price. A put option gives you as the buyer the right to sell an underlying instrument/stock at an agreed price within an agreed time period. The agreed price for the underlying instrument upon redemption of the option is called the strike price. The last date to redeem the options contract is called the expiration date. The buyer then has the right to redeem the options contract with the underlying 100 shares of the instrument.

Put options trading example

After Phil has done his due diligence, he has decided that the share TMV is overpriced at the current price of 100$. He also knows that the company will have a quarterly report soon, and expects that the result will be poor and that the share will fall in value after this becomes official. After a further investigation, he finds that a put option is a good alternative. He can then reap profits during this expected decline, but can also limit his maximum losses equal to the premium whether he has assessed the situation incorrectly. He, therefore, decides to buy the options contracts within the expiry date after the report comes out. Trading via a broker will look like this:

Buy / Sell = Here he selects Buy to open to buy options of the underlying instrument.

Quantity = Here he chooses how many options contracts he wants to buy with the underlying 100 shares per. option contract

Expiry = Here Phil chooses the expiry after the quarterly figures so that he makes sure that he will catch the possible price movement to the downside. Expiry is thus when the option contract expires and the rights will expire.

Strike = The price Phil wants to be able to sell the shares at.

Call / Put = Here he chooses Put, ie put options.

Price = Is the price for each option contract, ie what he thinks is an acceptable price to pay per. an option contract, more about this below.

Further explanation of trade

Phil decides to buy 5 x put option contracts, this corresponds to a position equal to (5 options x 100 underlying) 500 shares of the underlying instrument.

The closer the strike price is to the actual price of the underlying stock, the premium for the options will increase. Phil thinks it can be a pretty big downside if the numbers are as he has imagined, he also wants to buy a little cheaper option contracts. He thus puts the strike price well below today's price, also called out of the money (OTM). This means that it will not be profitable to redeem the option contracts with the current pricing of the underlying instrument in relation to the strike price. Phil places an order with a strike price equal to 90$, ie 10$ below the current price of the stock.

 

This means that he has the right but not the obligation to sell the share at 90$ regardless of whether the share price falls lower or is higher within expiry. It is therefore the issuer that takes on the risk and the promise to buy the shares back at the strike price. To take on this promise, he receives a premium that is paid when the trade and the contracts are agreed upon. In this fictional case, the price per option contract/premium has been set at 5$. This is the price per. an option contract, which goes to the issuer of the option.

The total price Phil pays for the trade is thus (5 option contracts x 100 underlying)  x 5$ (Premium) = 2,500$.  The maximum loss he can have on the trade is therefore this premium (plus brokerage fee). As you can see, options trading thus provides a limited downside risk. Let's look at what it takes for a trade to make a profit:

 

Phil has paid 5$ per. an option contract, which has a strike price equal to 90$. The underlying price of the share was in this imaginary case set at100$ when he bought these contracts. This means that he must have a price of the underlying instrument equal to 85$ to not lose money 0 on the trade. Anything under 85$ of the underlying instrument will make a profit, and the option contract will go to ITM (In The Money).

Long-Put-Options-Trading-Example-.jpg

Source: optionsbro.com

As you can see from the image above and as explained earlier, the maximum loss Phil can receive is the premium +  broker brokerage.

The trade can in theory give a profit all the way down to the share is at 0$, and he has a profit from 85$. What is important with such options is to hit on the date (expiry), as the contract expires worthless if he does not get the price reduction before the expiry has expired. It is therefore very important that this is based on the expectations of when Per believes the company's quarterly figures and reactions in share prices in relation to these occur.

Calculations of the trade  

 

Let's say that the underlying price of the options contracts Phil has bought has gone to 60$ before the expiry date. Below we show what profits Phil would have received in such a case:

Premium = 5$

Strike price = 90$

Underlying share price at redemption = 60$

Contracts = 5 (x100)

Calculation:

Strike price - Underlying - Premium = 25$ profit per. contract.

 

Profit:

25$ x 500 contracts = Phil would have 12,500$ in profit without counting brokerage fees in such a case.

As you can see, put options can in some cases be a lucrative and great way to make trades in companies and instruments. As mentioned, it is also a great way to reduce the downside risk when investing in instruments using specific strategies. The downside risk of buying pure option contracts is always limited to the premium only.

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