Buying Put Options, Simplified

Long put options offer a way to bet bearishly with limited risk

A put option is like a call in that it is a type of derivative that relies on the movement of the underlying stock to make a profit. Unlike a call option, a put gains value when the underlying stock moves lower. Buying a put is a bearish bet that gives the trader the right, but not the obligation, to sell the underlying shares for a specific price (the strike price) before the expiration day.

Let's again use the hypothetical example where Stock XYZ is trading at $39.50. The trader speculates that this price will decline in the short term and decides to buy a November 39 put, expiring on Nov. 16, for a $1.50 premium. In the case of a put option, the trader is hoping that the underlying asset will sink below $37.50 by the expiration date, which represents breakeven (put strike - premium paid) on the trade.

Let's say XYZ falls south of the $37.50 breakeven. The trader can make money one of two ways: exercise the right to sell the shares at a higher premium than their current trading price, pocketing the difference; or, sell to close the put option before the contract's expiration. The latter would allow him or her to profit off the gain in the option's premium. So, the lower the stock goes beneath breakeven, the higher the reward.

But what if XYZ rockets higher? Whereas a short seller'slosses can add up quickly, a put buyer's risk is limited. Like with a call, the risk on a put purchase islimited to the initial premium paid, making it a relatively conservative strategy for bears.