Put Options

A Put option gives the owner the right, but not the obligation to sell the underlying asset (a commodity or futures contract) at the stated strike price on or before the expiration date. They are called Put options because the owner of the option can “put” the underlying asset to the seller of the option. In other words the owner of the Put option can sell the underlying asset to the seller of the option at the strike price. Like with a Call option the buyer must pay a premium to have this privilege and this premium is the most the buyer is liable for and the most they could lose. As a buyer of Put options we hope the commodity falls in price because this will increase the value of the Put option, allowing us to sell the option later for a higher price than we paid for it. Try not to let the fact that we want the price of the commodity to go down, in order to make money, confuse you. The main principle “buy low, sell high” still applies, we still want to buy the Put option for a lower price than what we sell it for later. The only difference is that in order for a Put option to increase in price we need the commodity it is based on to fall in price.

Real Estate Put Option Example

Let’s pick up where we left off in our real estate example that we talked about in the article about Call options as an example of how to make money with a Put option when you know the price of something is going to fall. Let’s pretend the hotel chain knows that the land on which the hotel will be built is only zoned for farming use and that the local government may not allow them to have it rezoned for commercial property use. If it is not rezoned for hotel use the value will be drastically reduce since it can only be used as a farm again. This would drop it back to its original value of $100,000 before all of these deals had happened. In order to protect themselves and profit form the possible misfortune of this scenario the hotel chain approaches a real estate investor and tells him they would like to buy a Put option from them for $5,000. With this Put option the investor promises to allow the hotel chain to “put” or sell the property to them for $150,000. As far as the investor knows the property is worth $200,000 right now, so he is willing to receive $5,000 for this option’s possible obligation to buy the property for $150,000 if the hotel so chooses to do so in the next 6 months before the option expires. A couple of months later the hotel chain finds out that the local government will not allow the property to be rezoned, so they can no longer build the hotel there. Therefore, they tell the investor they want to exercise their right to sell him the property for $150,000. The investor is forced to pay $150,000 to the hotel chain to own the property which means it cost him $145,000 because he received $5,000 a couple of months ago for the option he sold. The hotel chain then limits their losses by selling a property for $150,000 that was only worth $100,000 now that it can only be used as a farm. By buying the option for $5,000 they were able to make $45,000 they would not have been otherwise able to make.

$150,000 from investor

—$5,000 cost of option

—$100,000 true value of property

$45,000 profit from Put option

Had the government allowed them to build the hotel they would have let the option expire worthless and lost $5,000 for the cost of the option. This is how money can be made with Put options when an underlying asset falls in price.

Futures Put Option Example

Now let’s use an example that you may actually be involved with in the futures markets. Assume it is now mid-September with December Gold futures currently trading at $1,400 per ounce and you think Gold is going to go down in. So you purchase a December Gold $1,300 Put for $10.00 which is $1,000 ($1.00 in Gold is worth $100). Under this scenario as an option buyer the most you are risking on this particular trade is $1,000 which is the cost of the Put option. Your potential is great since the option will be worth whatever December Gold futures are below $1,300. In the perfect scenario, you would sell the option back for a profit when you think Gold has bottomed out. Let’s say gold gets to $1,250 per ounce by mid-November (which is when December Gold options expire) and you want to take your profits. You should be able to figure out what the option is trading at without even getting a quote from your broker or from the internet. Just take where December Gold futures are trading at which is $1,250 per ounce in our example and subtract from that the strike price of the option which is $1,300 and you come up with $50 which is the options intrinsic value. The intrinsic value is the amount the underlying asset is though the strike price or “in-the-money.”

$1,300 Strike Price

—$1,250 Underlying Asset (December Gold futures)

$50 Intrinsic Value

Each dollar in the Gold is worth $100, so $50 dollars in the Gold market is worth $5,000 ($50X$100) to your account value. To figure your profit take $5,000 - $1,000 = $4,000 profit on a $1,000 investment.

$5,000 option’s current value

—$1,000 option’s original price

$4,000 profit (minus commission)

Of course if Gold was above your strike price of $1,300 at expiation it would be worthless and you would lose your $1,000 premium plus the commission you paid.

As you can see, buying Put options allow you the potential to make money should a futures market fall in price. Of course it needs to fall far enough below your strike price and before the options expires for this trade to work, so in addition to choosing the correct market direction you need to be careful to choose the right strike price and expiration date for your trade to be profitable. If you are incorrect with the trade you may lose some or all of the money spent on buying the Put option.