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What Are the Pros and Cons of Put Options?

Jim B.
Jim B.

Put options are financial instruments that allow investors to trade in options to sell 100 shares of a particular stock at some point in the future. Giving investors this option allows them to take either a positive or negative position on a stock for a relatively small price. In addition, put options make for good hedging instruments against other stock positions. The downside of a put option is that if the price of the underlying security moves in the opposite direction of where the investor anticipates it to go, there could be a substantial loss.

Put options are one of two main types of options traded by investors. Call options allow for investors to buy shares of a stock at some point in the future, while put options give them the right, but not the obligation, to sell shares of the underlying stock. The option may only be exercised if the stock price reaches a level known as the strike price, which is stated in the option contract. Also stated in the contract is the premium, which is the price that the option buyer pays for the contract, and the expiration date, a point in time at which the contract becomes worthless.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

The main advantage of buying put options is they give investors the chance to speculate on securities that they feel may be headed for a fall in price. For example, imagine an investor buys an option to sell 100 shares of a stock at the strike price of $20 US Dollars (USD) per share. If the price falls to $10 USD per share, the option holder gets to exercise the option, buy the shares at $10 USD per share, and then sell them to the option seller at $20 per share, pocketing the difference for a nice profit.

It is important to realize that put options may be bought or sold, which means that investors can take positions depending on the direction they think the price of the underlying stock will go in. In addition, buying a put option is a good way for investors to hedge. An investor with a lot of shares in a particular stock might want to buy a put option to protect against the price of that stock falling.

As is the case with any investment opportunity, put options can do damage if the price goes in the opposite direction from what the investor is hoping. This could be especially damaging in the case of those who are selling these options. Whereas option buyers are only at risk for the premium paid for the option, option sellers, or writers, can suffer limitless losses.

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