Options trading 101: The ins and outs of put options

Julie Brownlee, Fsp Invest, 03 Sep. 2014

Tags: put options, options, what are options, what are put options, trading options

Options trading is by far the most popular trading tool in the US. Now options are starting to gain momentum in South Africa as a trading instrument.

But to start trading options, there are a few key terms that you need to get to grips with. And one of these is put options.

So what exactly are put options? And how do they work?

Let’s take a close look…

What are options?

Options give you the right, but not the obligation, to buy or sell something (such as shares) for an agreed price on or before a certain date.

To purchase an option to buy or sell shares, you need to pay a fee to the seller of the option. The fee is known as the premium. And the seller is known as the writer.

In South Africa, options are based on single stock futures, which are in turn based on the underlying share.

What are put options?

If you want to put on a short trade with options, you need to use put options.

Put options gives you the right, but not the obligation, to sell a share.

For example, you think the value of a specific share is going to fall and you want to make a profit from this happening. If this was the case you’d buy put options.

Who uses put options?

A lot of fund managers use put options as a form of hedging their portfolios.

For instance, they could buy put options on a stock market index to protect their portfolio against a fall. If the stock market does take a tumble, the put option would help offset a fund manager’s losses in his portfolio.

You could employ a similar strategy with your portfolio.

How options contracts work

In South Africa, as options are based on the single stock future of the underlying share, the contracts are made up of 100 shares each.

For example, let’s say Company ABC is trading at R100 a share. A put option premium to sell at R90 costs R5. That means the cost of the option is R500 (R5 x 100).

If the shares fell to R70, you could make a profit of R1,500 ((R90-R70-R5) x 100).

If the trade doesn’t work out as you thought it would and the share price rises, you can let the option expire. Your loss would be the premium you paid, but nothing more.

If you wanted to buy an option on a share you thought was going to rise, you’d buy call options.

So there you have it, the ins and outs of put options.

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