What is a put option and when does a options trader buy or sell put options?

When an options trader thinks that a stock will go up in price he could buy the stock or, for much less, sell a put. When the trader sells the put option he or she receives a premium and undertakes the obligation to buy the stock at an agreed upon price, the exercise price or strike price if the buy wishes. If the price of the stock goes up the buyer of the put will not want to sell and the seller of the put will gain the premium.

If, on the other hand the stock price drops the put buyer will want to exercise his right and the sell will have to buy the stock at the exercise price when, indeed, it may be worth substantially less. Selling a put when one does not have the cash to cover a loss is called an uncovered put or naked put. The downside potential on an uncovered or “naked” put can be the exercise price of the stock if the stock itself goes to zero.

Options traders can buy and sell puts. Buying a put is often a defense strategy for the owner of a large stock position after a substantial run up and a very volatile market. Buy paying the cost of the put the stock owner protects his or her position against substantial loss. Because the buyer of the put is under no obligation to sell his or her stock he or she can pay a little “insurance” to protect a stock position against loss and still control the stock if the price, in fact, goes up.

More complicated approaches to put options are approaches such as long straddles where the options trader will purchase both a call option and a put option on the same stock at the same strike price. The options trader can make money if the stock moves substantially in either direction, and will only lose the price of the options if the stock stands still.

In the case of buying and selling put options a stock owner may be protecting a stock position or a stock trader may be looking to leverage a small amount of capital into a large gain such as with a long straddle. In the case of selling a naked put the options trader is betting on gaining the premium and not losing his or her shirt with a precipitous drop in the stock price.

Let’s look at what our options are in trading call options. There are call options and put options each of which you can buy or sell. You will buy or sell call options depending upon whether you believe a stock is about to go up or down.

An options trader who thinks a stock’s price will go up can purchase the stock or, for a much lesser amount, purchase a call option on stock at or near the current price. This means the options trader has the right to purchase the stock at any time up until the expiration date of the call option, at the set price called the strike price or the exercise price regardless of what the market price, the spot price, is. If the stock does not go up the trader is under no obligation to buy. If the stock goes up the trader has the right to buy.

The price of a call option is based on what traders think is the value of the option and upon the difference between the set price for buying the stock and current stock price. If the consensus of options traders is that the stock is very likely to go up the price of the call option will reflect that fact and be more expensive. If options traders believe that the stock price will go down or stay the same then the price of the option will be low.

The risk in buying a call option is that the stock will not go up enough (or not at all) to warrant exercising the option and buying the stock. The risk of selling a call option is that the stock will go up spectacularly and you will miss out.

In selling call options you are betting that the stock you own will not rise sufficiently and that at the end of the term of the option you will still hold the stock and be richer by the price of the stock option you sold. In general only owners of stock will sell options because, if the price goes up spectacularly, they will not need to go into the market and buy at a high price in order to sell the stock at the previous low price.

Options traders who buy call options typically are not interested in long term stock ownership. The idea is to use a smaller amount of capital to purchase options on stocks that are about to go up. When that happens the purchases exercises the option, buys the stock and promptly sells at the higher price. The gain for the successful buyer of a call option is the higher price minus commissions and minus the price of the option.

Both buying and selling call options have their place depending upon whether or not you already own the stock and whether you believe the stock’s price will go up or down. Investors typically sell call options and traders typically buy call options.