Put Options – How does it work? Should you Exercise it?

Options

Definition of Put Options

A put option is jargon, which is commonly used in the trading shares at stock markets. Anyone who holds a put option has the right to trade the shares of equity, at a given price. These options also carry an expiration date, so anyone who holds them must utilize them before the date and time of expiration. The put option price is commonly known as the strike price. If the person who holds the option, wants to use his right to exercise the option, the writer who wrote the option, would have to buy these shares.

It is one of the many ways for stock traders to avoid losing their investment. But it is a bit of a complicated process and the user must understand it before diving into it. The Put Option gives the user certain leverage over the writer but if you do not understand the system properly, you might have to face the call action. Similar to the put option, there is also a call action, both of these act contrary to each other. In trading terms, a put option is known for selling, and a call option is known for buying.

How does it work?

To successfully exercise it, you need to know how it works, otherwise. You will not be able to profit from it. Before moving further, you need to know that it all depends on the prices of the stocks or shares. Your option expiry will determine whether you will be making money in profits. Or you will be losing whatever you have invested in that option. You will make money if your option expires in the profit, but you will lose money if your option expires unprofitable.

Two more terms that commonly emerge here are known as “in the money” and “out of the money”. In the money means that your option expired profitably. And you made some money, or gained value. The out-of-money term means that you lost some money because your options expiry was unprofitable.

Think of it as you if you are betting against the value of the shares or stocks. The value of your put option premium will increase if the price of that stock or share goes down. But if the price of that share goes up against your betting, you will lose your premium and your investment. It is one of those tools that help investors make money while the stock prices plunge. It also acts as a safety net for investors to protect them from the decrease in stock values, they bet on it and make a profit from it, instead of losing their investments.

Example of Put Option In Work

You will better understand this system with the help of an example. Let’s talk about a person who bought some shares in one of the renowned companies whose share prices have been going downwards. And the company has moved from top to bottom in the position. That person bought a put option of 100 shares at a certain price, for example at the price of $15 each. After this, an option writer. Who will buy these shares from that person at the price of $15 each? Now, if the price of that stock goes below $15 it can help the person who holds the put option make it again. But you will have to cover the costs of commission and premium. For this example, we assume that these costs are about $2 per stock.

15-2 equals 13, if the price of these stocks goes below $13. The person who holds the put option will make a profit. Now, the investor is not only protected from the reduction in the price of his shares, but he will also be able to make a profit through this by using the put option. Consider that the new price of the shares is $10 each, and the put option is exercised, the investor will be able to sell these shares at the price of $15 instead of $10 hence making $5 more on every share. After the deduction of commission and premium, the investor will still have $3 per share profit from his option.

Now, there are two things to consider from this example, first, the investor was willing to pay the premium to protect his investment, and was able to make a profit. But if the prices didn’t go down, and had instead increased in value, this would have resulted in a very difficult situation for the investor, as he would have to pay the premium and he would have lost the put option.

Short Position Transaction

Short position transactions are also very common in the trading of stocks and shares. Think of it as the transaction, when an investor sells the stock first at a higher price for a short term and then buys the shares back when they are at a low price. This is known as short selling or short trading. In this scenario, the investor does not own any stocks but instead has bought a put at a certain price.

The actual price of the shares is lower than the put. We can take the prices from the previous example here. The buyer has bought a put option at $15 but the actual price is at 10. After covering the premium and commissions, he will still make $3 from each stock. Now, when the investor initiates the put at $15, it initiates a short position at 15$ which can be recovered later by buying these same stocks at a lower price of $10.

But this type of trade needs a special account, known as the margin account. This account should hold the money that is enough to cover the margin of the actual account. It is an account of the brokerage, from which the investor buys the shares or stocks with cash or equities as the collateral. When you are using a short position transaction, you must be very careful with it. There is a chance that other investors may start to do the same with the specific stock, and it would backfire. It would backfire in a way that would result in an increase in the price instead of the price going down.

When the price of short stocks goes up, it would cause the investors who have invested input options on the stock to lose all of their investment in the stock. You may have heard about the game stop scenario. Where a lot of investors had shorted the stock because its prices were going down. But a group of other investors from Reddit started to buy these stocks. It resulted in an actual shortage of stock and many of the renowned investment firms in wall street took a hit. For that reason, you need to be careful when investing in a short position transaction. It can help you make money, but if you are not careful, it may result in loss of investment as well.

Should You Exercise it?

It depends on your circumstances. For example, if things are going as predicted, and prices of the put option shares are falling. You should exercise it, but if things are not going as predicted. You should not exercise the put option. Because it would result in loss. To make sure that you do not lose your investment in stocks of a certain company. You should maintain a put option to protect it. But you should only exercise it for the short position trading if you are certain of the outcomes. There are a few things that you should consider before exercising. Here is a list of those things that you must consider before exercising it.

  1. Time: Time is of great value when it comes to options. It determines the real value of the option. For example, an option with a short time remaining will have less value as compared to the one with a long time remaining from the expiration date.
  2. Risk Increase: You need to keep the risks in mind before deciding about holding or exercising the option. For example, if you hold the put or call option, and odds move against you, you will lose your entire investment but if you convert your option into shares, you will only use a small amount.
  3. Transaction Costs: As you are paying commission for every trade, it is worth considering the cost of the transaction. Otherwise, it would impact your overall profits badly.

Conclusion

From the discussion above, a few things are clear. The put option is one of the best tools that you can use while trading in the stock market. It helps you make it again and protect yourself from the loss or decrease in the value of shares. All at the same time. But it also carries some risks. So, you need to be very careful while using it.

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