What Is a Put Option? Put Option Definition.
A put option, also called a put, is a contract that gives the buyer the right to sell a security at a pre-set price (strike price) in a certain time frame. There’s no obligation to sell, hence the word option.
Put options are often used for hedging and speculating on downward price movement because the option becomes valuable when the underlying asset price drops.
How Does a Put Option Work?
“A commodity put option contract gives the buyer (also known as the purchaser or holder) the right, but not the obligation, to sell a specific futures contract at a known fixed price at any time before or on a certain expiration date. In acquiring this right, the buyer pays a premium (payment) to the seller of the option.”
Anderson et al., 1999
A put option is considered “in the money” if it has intrinsic value, determined by the difference between the strike price and the underlying asset price. The time remaining until the contract expiration impacts the price and is referred to as “time value” or “extrinsic value.”
A set amount will be tacked onto the put option price as time value because the asset price can still change.
Investors can use put options, called protective puts, to manage downside risk on a certain asset. If the security price drops, the put option hedges against the loss. If the put is exercised in these cases, the investor sells the stock at the strike price.
Suppose the investor doesn’t own the underlying security and exercises a put option. In that case, this creates a short position, meaning the investor intends to buy the asset in the future at a lower price.
Buying Put Options
Put options in crypto are bought on an exchange and require the investor to enter several variables to confirm their desired contract terms. This includes the underlying asset, put expiration date, strike price, and premium (cost of the option). The premium is due to the seller when purchasing the option.
Each option typically represents 100 shares of a given asset. However, prices are listed in terms of the price per share. When buying a put option, it’s smart to determine the breakeven price – the price the asset needs to hit to be in the “money.” Once the expiration date hits, the option no longer exists.
Put option buyers make money when the price of the underlying asset drops. This is because they have the right to sell the asset at a higher price than they’d need to buy it to exercise the option.
A put owner can exercise the option contract to sell the asset at the strike price, or it may expire with no value. The owner can also sell the put option to another buyer before the expiration date.
How to Buy a Put Option
- Create an account on an exchange that has options contracts available (i.e., Binance)
- Complete identity verification and any pre-screening tests to confirm you’re knowledgeable enough to trade options
- Add a valid payment method, whether a debit/credit card or bank account
- Research and monitor cryptocurrency prices to identify potentially promising coins for trading options
- Look at available put contracts and choose ones in line with your risk tolerance and investing strategy
- Purchase the option from the seller, paying them the premium
- Set alerts for price movement and check regularly for the price to dip below the breakeven point so you can decide when to sell
Selling Put Options
Put options can also be sold, with the benefit of getting the premium payment up front and having the potential to make a return if the underlying asset stays flat or goes up in price.
Put sellers want the put option to become worthless and expire without being exercised. Then, they can keep all the cash they received up front, which is the maximum they can make from selling. It’s a solid way to make returns, but it doesn’t multiply investments as buying put options can.
If the asset’s price falls and the buyer makes a return, the seller loses part of their premium and may even receive a margin call, requiring them to add money to their account.
How to Sell Put Options
Selling put options may require getting approval from the exchange you want to sell on. That confirms that you’re familiar enough with trading options to write puts and have the necessary funds.
You may need a dedicated margin account before you can start selling put options, and you should ensure you have more than enough funds available in case you receive a margin call.
Once you’re approved, you can start identifying puts you’d like to sell and use the exchange to find interested buyers.
Example of a Put Option in Practice
Imagine one ETH is trading at $2,500. You can buy a put option on Ethereum with a $2,200 strike price of $25, with an expiration date of one month away. This contract costs $2,500 to purchase, as each of the 100 shares costs $25.
If Ethereum’s price drops to $2,000, the option is in the money, and you’d make a return of $17,500.
The difference between the strike price ($2,200) and the market price ($2,000) is $200, which is multiplied by 100 shares to get $20,000. The original premium, $2,500, is subtracted from this amount to get the return, $17,500.
If ETH fails to drop to $2,200, the option will be worthless and expire, leaving you out $2,500 for the premium.
Final Thoughts
Put options are a high-risk, high-reward investment instrument that gives buyers the right to sell an asset at a set price. They rely on volatile price movements, which are prevalent in crypto, making it an interesting space to explore put options.
Anderson, C., Mccorkle, D., O’Brien, D. (1999). Hedging with a Put Option, AgriLIFE Extension. https://www.researchgate.net/publication/26905287_Hedging_With_a_Put_Option
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