A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Insurance is a classic example. If you buy insurance on a house worth $250,000 because you fear something happening to it, then you can buy an insurance policy to ensure that the value doesn’t drop beyond a certain level. The premium paid to the insurance company to protect a drop in value below $250,000 is what we call a put. In the case of insurance, the time period is one year and you will have to renew it each year.

As you can see from Figure 7, the profits and losses change as the price of the underlying moves higher and lower. The insurance or Put will go up if there is more uncertainty in the market, or if the underlying asset will go down in value. The price of the Put will go down if there is less uncertainty in the market or if the underlying asset increases in value.

Put Option Attributes

1. Strike Price Selection

In the case of an insurance policy, the Strike Price is the value at which you want to sell your house in case of an event in the future.

2. Expiration Month

This determines the duration-in the case of insurance it is one year. For options it can be weekly, monthly or quarterly according to your convenience.

3. Premiums

You’ll need to be comfortable with the option premium. You can use the binomial equation to determine the option price going into the future. For a put option, the price goes up when the underlying asset decreases in value, or the Implied Volatility increases, or the interest rate or dividends increases. All these attributes are figured in the binomial equation for determining the option price.

4. Assignment and Expiration.

If you are assigned on a put that was sold and the price of the short stock rises suddenly, you will lose money. In Figure 7, x-axis represents the price of the underlying asset and the y-axis represents Profit/Loss. As the price of the underlying asset falls, your profit increases. But if the underlying asset price rises, you will lose money. If you own a put, the contract loses value over time (all else being equal) and the losses are limited to the premium paid. This is why it’s important to keep track the expiration, as the option ceases to exist after it expires.

Points to remember

• Time Range Selection: If you buy insurance on the house, it is for twelve months or one year. If you are trading in Apple earnings, and Apple earnings is going to happen in a month, you will have to trade in options that expire in more than a month’s time.

• Directional Bias: You have to have a directional bias in order to be a successful trader. A put purchase represents a bearish directional bias on the underlying asset.

• Volatility: High Volatility means high uncertainty, which will mean you will have to pay higher premiums for options. You have to learn how Implied Volatility works for an underlying asset. If you are approaching a binary event and you have uncertainty in the underlying asset, the Implied Volatility will go up and so will the price of the put option.

• Hedge: You can use Puts as a hedge mechanism. Suppose you have an underlying Stock or an underlying house and you want to buy insurance, then you can purchase puts. One put hedges 100 shares.

• Risk vs Probability of Success: As you get more experienced, you will realize that it makes more sense to sell out-of-the-money puts when you are bullish as this will reduce your cost basis and improve your Probability of Success. Also you will learn to be more proactive in defending your position when needed.