A put option allows the buyer of the options the right, but not obligation (this is important!) to sell a specified asset at a specified price on a specified date. Lots of specifics right? And right now it might sound confusing, but it’ll make sense shortly enough. So what is a put option in layman terms?
Truthfully, there is no layman terms or way to define put options as they are semi complex financial instruments. More or less, options allow investors to “gamble” on the future, and also to buy a sort of insurance for their stocks and other assets.
Before we go any further, you should know that options are higher risk than many traditional investments, such as blue chip stocks and bonds. They are not the highest risk investments out there, but at the same time you should be cautious when investing in them. At the very least, make sure you’re well educated and you know what you’re doing.
Anyways, let’s go over a put option example in order to fully illustrate what these financial instruments are and to shed light on a put option definition.
Put Option Example: Apple Inc. Options
Let’s say Apple is going to release their latest generation of iPhone in a month. You’ve been reading online leaks and tech websites, and you’ve come to believe that the iPhone will be a huge failure. Thus, you believe that Apple’s stocks will drop in the future.
Remember that definition of put options? It gives you the right but not obligation to buy assets at a specified price at a specified point in time. In other words, you could buy put options that guarantee your right to sell Apple stocks at $100 dollars a share. So even if share prices do drop, and hopefully they do if you buy put options, you can still sell shares at $100.
(Note: you don’t have to physically own the shares, you just have to buy the options. Options are actually derivatives, they derive their value from the price movement of other assets.)
Buying Options Vs. Short Selling Stocks
So why would you buy options instead of just short selling stocks? After all, short selling is an easy way to make money off of dropping stock prices, so why not just buy stocks? Stocks are much more expensive than options. Let’s say Apple shares are selling for $100 dollars a share, if you wanted to buy ten shares you’d have to pay $1000. If you wanted to short sell, you’d have to have money on hand to cover dramatic price increases of 20% or 30% or more.
Options generally sell for a fraction of the asset’s underlying value. For example, a put option to sell Apple five weeks from now (and thus one week after they unveil their new phone) might only cost $10 dollars. If you had only a thousand dollars to invest, you could still buy a hundred Apple options!
Your profit would then be the total difference between right the option price gives you, the market cost of Apple shares, and the cost to buy Apple stocks. Let’s say Apple’s phone bombs and Apple prices decline from $100 dollars to $75 dollars a loss of $25. Minus the cost to buy the options (so: $25 – $10), you’d make $15 dollars a share. Times that by 100 options and you’ve made $1,500.
The Difference Between Call and Put Options
Call and put options are basically opposites. A call option allows you to buy assets at a specified price on a specified date. To put this into context, let’s go back to the Apple example above. Let’s say you believe that Apple’s newest iPhone is going to be a smashing success.
You could buy Apple stocks, but you only have $1,000 dollars and Apple stocks are selling a $100 dollars a share. Even if you invest all of your money in Apple, and the iPhone is a huge success, you’ll likely only make a couple hundred bucks. You’re extremely confident in your prediction, however, and you want a way to earn better returns.
So you can buy options instead. Let’s say options to buy Apple at $100 dollars are selling for $10 dollars. Instead of buying 10 shares, you can buy 100 options. Then, let’s assume that you are proven correct and the iPhone becomes a huge success. Stock prices immediately jump to $130 dollars. Now, you can exercise your options and lock up a profit of $20 dollars a share (you get thirty dollars for each share you optioned, but you had to pay $10 dollars for the option itself).
In sum total, you’d make $2,000 dollars! That’s a heck of a lot more than a few hundred bucks. Remember, however, if you’re proven wrong, you will end up suffering much higher losses, and could potentially lose all of the money you invested.