How do put options work in finance? what do buyer/sellers get out of it?
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You can sell a call for a $100 share of stock for something like $20. Which for simplicity $100 is the marlet price. The relative prices are set by the market.
The seller hopes the value of the stock goes down. They get to keep their $20 and the call expires unexercised, meaning the buyer gets nothing.
The buyer hopes the stock goes up by more than $20. Then the seller needs to sell him a share of stock for $100. Since the stock went up by more that $20 the buyer wins out.
If the stock price goes up by less that $20 the seller still wins, but his profit is reduced by the increase in stock price.
So it’s really a way to bet on stock prices and you can do it at a leveraged rate. Above the buyer was able to benefit from the upside of the stock and didn’t have to buy a whole share for $100, just an option at $20. So you can get 5x the upside.
Put options give the right, but not the requirement to sell an underlying security at a specific price during a specific period.
The buyer of a put is someone who is looking to protect a position they think may lose value, essentially an insurance they can get a certain price for their position if the price on the open market is lower than the put option.
The seller of a put option is looking to gain value from the actual sale of the option in hopes that the underlying position will go up in value and they will not have to buy the underlying position at a higher value than is available on the open market.
They work just the same as a call option, except the option owner chooses to sell their asset rather than buy.
Let’s say you’re selling apples on the market, and the current price is 5 cents. I offer you an option saying that tomorrow, you can sell me an apple for 6 cents if you want.
If tomorrow comes around and the market price is still 5c, you can choose to exercise your option and I have to buy an apple for 6c, 1c above market price. If, on the other hand, the market price tomorrow is 7c, you would not want to exercise your option because you’d make more money selling your apples on the market.
In this crude example the option was free, but in real life it would cost some money up front and you don’t get the fee back regardless of whether you choose to exercise the option.
In simple ELI5 terms:
Assume we’re talking about put options on publicly-traded company stock shares.
A buyer of a put option can sell the underlying stock at a set price (called the “strike price”) any time before the option expires. What a buyer gets out of it is insurance. If the buyer already holds the stock, the put option rises in value as the stock value goes down, protecting the investment. The small cost of the put option is the price of that insurance. If the stock goes up, the option expires worthless (the buyer loses this small initial cost) but the stock price goes up.
A seller of the option is obligated to buy the stock at the strike price if the option buyer decides to exercise the option. The benefit to the seller is that most options expire worthless and the seller gets to keep the premium (the buyer’s cost) of the option when the option expires. The risk to the seller is that the stock price goes down too far, in which case the option seller may be forced to buy the stock at the strike price, which may be higher than the actual stock price.
Options are intended to be used as “insurance” but they can also be used in speculative and leveraged investing strategies.
Let’s say you own 100 shares of XYZ valued at $100. You’re OK if the stock goes down a little but you can’t really afford for it to go below $90. You could set a stop loss order but that won’t do you any good if the price gaps down below $90 at the market open or if there’s liquidity issues in executing your order at $90. It can also go back up right after and you’d lose out on the recovery. The solution would be to buy a $90 Put option. This will give you the right, but not the obligation to sell your shares at $90 until a specified expiration date in exchange for a premium. If the stock tanks and goes to $0, you will still have the contractual right to sell your shares at $90. If the stock drops to $80 but then recovers back to $100 you do not have to sell at $90 and can continue holding on to your shares.
On the flip side you can use a call for similar measures. Let’s say XYZ is currently trading at $100. You want to buy 100 shares of XYZ but you don’t have the moneg ready yet. You can then buy a call option at $100. This gives you the right but not the obligation to buy 100 shares at a price of $100. So if the stock goes up to $120 before you’re able to buy the shares, you won’t have to miss out on the gains since you will have the right to still buy in at $100. If the stock falls below $100 you aren’t obligated to buy in. From a speculation standpoint, you could buy call options if you want to speculate on the stock going up. Let’s say March options for $100 are trading for $5 in January and you buy one, if the stock goes to $120 by expiration in March, then you can sell the option for $20 and make 3x the original investment even though the underlying stock only increased by 20%.
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