What are put options, and how can they help your portfolio?

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Here’s what you need to know about put options. / Credit: lOvE / Getty Images

When it looks like markets are about to fall, as they have recently, some investors look for short-term alternatives to stocks and other traditional long-term investments. Put options are one such choice. Put options are a bet that an underlying security like a stock will fall. Investors sometimes use put options to buffer against losses when the market price of a security – like a stock – goes down. Investors also use put options to make a profit. They can be risky if the underlying stock rises, you can lose money.

Before buying a put option, you may want to consider consulting with a financial adviser to review your portfolio and determine if that’s the best financial option for you. There are several options available to you.

A financial adviser can review what exactly a put option is and how it works – but it never hurts to come prepared. Here’s a brief overview.

Stay on top of your portfolio with Morningstar What is a put option?

A put option is a contract written to grant a buyer the right to sell shares of an underlying security (like a stock) at a specific price during a set period of time. This locks in a predetermined value. The buyer, or holder, isn’t obligated to sell the put option, but once the contract expires it’s worthless.

Put options can offer “defined risk” or limited risk for buyers because the holder won’t lose more than the price paid (called a premium) if the contract expires without the option being exercised, traded or sold.

How do put options work?

Stock options are sold as contracts. A single contract represents 100 shares of the underlying stock. For example, if a put option contract is priced by an exchange at $3, the cost to buy the contract is $300, or 100 times the option value. That $3 is called a premium – the price paid for the right to sell the stock at a certain price within a certain timeframe.

A financial adviser can help walk you through the process and thoroughly explain the benefits and risks that come with put options. See if it makes sense for you to buy a put option or if you should refrain. A put option’s value rises when the price of its underlying stock falls. If the market price climbs, then the value of a put option drops and becomes worthless.

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Imagine company A’s stock is trading at $100 in June. When you buy a put option that expires in a month, you have the right to sell at a “strike” price of $100 during that time frame. Now imagine company A’s stock falls to $80 sometime during the contract. Because your put option is “in-the-money” or below the “strike price,” you can opt to “exercise” your option to sell at $100. The writer, or original seller of the contract is obligated to sell the underlying stock to the put option contract holder at $100, even if their market value is $80.

Using the above example of a $3 put option contract, selling the put option means you would reap $20 per share ($100 minus $80 times 100 shares) or $2,000. If you subtract the $300 premium paid when you purchased the put option, you’d end up with $1,700 before expenses.If company A’s stock doesn’t fall below $100, your put option is “out-of-the-money.”

If you already own a put contract but want to get out of it before the expiration date, you can “close” your position by selling the same option contract you purchased either at a profit or loss.

When your put option contract expires, it’s no longer valid. The put option’s seller keeps the premium you paid.

How to buy and sell put options

To buy and sell put options, you must open an account with an options broker. The broker assigns a trading level to your account. Make sure you carefully study how to fill out the forms, which can be complicated. Your account will also have a form for selling put options tied to the strike price.

A put option contract can help protect its buyer, or holder, against losses within a specified time frame should the underlying stock price fall.

Your put option can also be profitable, depending on the underlying asset price and the premium paid for the contract.

Alternatives to exercising put options

You can sell option contracts or trade them before their expiration date.

You can let the contract expire. You won’t profit. In the example above, though, you may have spent $300 to protect against potentially bigger losses.

What happens when you exercise a put option

When the put option contract holder exercises the right to sell, the initial seller, or “writer,” gets an “assignment notice” that they must respect the contract by purchasing the underlying asset at the strike price.

What is a call option?

A call option is basically the opposite of a put option. It’s essentially a bet that the contract’s underlying security will rise. Call option buyers can profit if the underlying asset climbs past the strike price, minus the option contract premium paid.

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