What Are Put Options? How to Buy Put Options

TL;DR

• Put options are contracts that let you sell an asset at a specific price.
• Puts are typically used to hedge against a position or rake in gains from significant price declines.
• Trading put options can be complex to understand and involve risks like time decay and IV crush.
• Puts are vastly different from call options and short selling, but serve similar purposes.
• Considerations when trading put options include deciding on specific strike prices, expiration dates, and premiums.

What Is a Put Option?

Also called 'puts', put options are financial derivatives that offer the buyer the option to sell a specific amount of the underlying cryptocurrency at a set strike price within a defined time period prior to the contracts' expiry date. What's worth highlighting is that the buyer of the put option isn't obligated to sell, but may exercise their right to sell. That right is defined by the conditions of the contract.

Put options represent a powerful trading instrument in the derivatives market. Unlike traditional spot trading where you directly own the asset, put options provide you with the flexibility to profit from price declines without actually holding the underlying cryptocurrency. This characteristic makes them particularly valuable during bearish market conditions or when you anticipate short-term price corrections.

Put options are essentially the opposite of call options, which provide their owners with the option to buy the underlying asset, such as a coin or token. Like puts, calls have premiums that vary based on their expiration dates and strike prices. The premium you pay for a put option represents the maximum loss you can incur, which provides a defined risk profile that many traders find appealing compared to other bearish strategies.

Puts Explained: How Does a Put Option Work?

Put options allow you to sell the underlying asset, such as cryptocurrency, stock, or something else of value. With options, the trader has no obligation to buy or sell. This flexibility is ultimately what makes them popular among both retail and institutional traders.

Puts are in the money (ITM) when the asset's last-traded price is below the strike price of the put contract when the expiration date arrives. From here, put buyers have the choice to exercise their right to sell the asset at the dictated strike price and reap the gains that comes with the price depreciation of an asset. The ITM status means your put option has intrinsic value, as you can sell the asset at a price higher than the current market price.

If the put contract expires out of the money (OTM), where the asset's last-traded price is above the strike price of the put contract when the expiration date arrives, the put expires worthless. In this scenario, the put option has no intrinsic value because there would be no advantage to selling the asset at the strike price when you could sell it at a higher price in the open market. The premium paid for the option becomes your total loss.

Understanding the mechanics of ITM and OTM is crucial for successful put options trading. The relationship between the strike price, current market price, and time to expiration determines the value of your put option at any given moment.

How Do Put Options Make Money?

The way put options make money is fairly simple, but understanding the calculation is essential for evaluating potential trades. Let's assume that a crypto options trader purchases a put option for ETH for a premium of $80. Let's also assume that the strike price for the contract was $2,000. If the underlying asset's last-traded price slumps to $1,900 at the time of put expiry, then the put will be considered ITM and be worth $100 at expiry. This $100 represents the difference between the strike price ($2,000) and the current market price ($1,900).

Discounting the original payment of $80 for the put option, the trader gets to keep $20 as pure gains. This represents a 25% return on the premium invested, demonstrating how put options can provide leveraged exposure to price movements. The percentage gain can be substantial even with modest price declines in the underlying asset.

Conversely, if the price of ETH trades at $2,100 at the time of the put contract's expiry, then the put expires worthless. In that case, the crypto options trader would see a maximum loss of their original $80 premium. This defined maximum loss is one of the key advantages of buying put options compared to other bearish strategies like short selling, where losses can theoretically be unlimited.

The profit potential of put options increases as the underlying asset's price falls further below the strike price. For example, if ETH dropped to $1,800 instead of $1,900, the same put option would be worth $200 at expiry, resulting in a net profit of $120 after deducting the $80 premium.

Advantages and Disadvantages of Trading Put Options

Advantages of Trading Put Options

Easy Way to Trade for Downside Gains

The greatest advantage of buying put options is the potential for substantial gains when the price of the underlying coin or token falls. If you're predicting a massive near-term slump, trading put options may be ideal since they offer leveraged exposure on the short side for specific coins or tokens while only requiring a small upfront premium. This leverage effect means that a relatively small investment in put options can control a much larger position in the underlying asset, amplifying your returns when your bearish thesis proves correct.

For example, instead of short selling $10,000 worth of cryptocurrency and facing unlimited risk, you could purchase put options for a fraction of that amount and achieve similar downside exposure with limited risk. This capital efficiency makes put options particularly attractive for traders with smaller account sizes.

Risk Mitigation

Another plus point of buying puts is that they serve as insurance for your underlying spot holdings during market drawbacks. Since puts give you the option of selling at a specific strike price, if the puts end up ITM, you can opt to exercise the put option and sell your asset at that specified strike price. This ultimately lets you hedge with options against market corrections while maintaining your exposure thanks to your long holdings.

This hedging strategy is commonly used by long-term investors who want to protect their portfolio value during periods of expected volatility. For instance, if you hold a significant amount of Bitcoin and anticipate a short-term correction, purchasing put options allows you to maintain your long-term position while protecting against downside risk. If the market drops, your put options gain value, offsetting losses in your spot holdings.

Flexibility of Crypto Options Strategies

Trading put options can be influential towards various different trading goals and risk management objectives, since options strategies involving puts and calls help to limit risk while giving exposure to the crypto market. With crypto option strategies like strangles, straddles, and protective puts, you can take advantage of any spikes in implied volatility (IV) and reap the gains.

Advanced traders can combine put options with other instruments to create sophisticated strategies tailored to specific market conditions. For example, a protective put strategy involves buying put options while holding the underlying asset, creating a floor for potential losses. A bear put spread involves buying a put option at one strike price while simultaneously selling another put at a lower strike price, reducing the upfront cost while capping maximum profit.

Disadvantages of Trading Put Options

Time Decay

Also known as the Theta portion of the Option Greeks, put options lose value over time, especially as their expiration date approaches. This is known as time decay. If the underlying asset's price doesn't decline significantly before expiration, the put option may expire worthless, resulting in a total loss of the premium paid.

Time decay accelerates as expiration approaches, with the most rapid decay occurring in the final weeks before expiry. This means that even if you're correct about the direction of price movement, timing becomes critical. A delayed price decline might result in losses due to time decay eroding the option's value faster than the underlying asset's price movement can compensate.

For instance, if you purchase a put option with 30 days to expiration and the expected price decline doesn't occur until day 25, much of the option's time value will have already decayed, potentially reducing your overall profit or even resulting in a loss despite being directionally correct.

Risk of IV Crush

Put options become more expensive when IV is high as more crypto options traders begin to bid up the prices of puts in the expectation of a near-term catalyst causing some form of volatility. After the catalyst event occurs, this will likely result in a crash in IV, which can lead to a significant loss in the premium value of the put option, even if the underlying asset's price moves in your favor.

IV crush is particularly common around major announcements, regulatory decisions, or significant market events. Traders who purchase expensive put options before such events may find that even if the price moves as anticipated, the collapse in IV reduces the option's value, resulting in smaller gains or even losses. This phenomenon makes timing and IV assessment crucial components of successful put options trading.

Complexity

Understanding and effectively trading put options requires a solid grasp of option pricing theory, risk management, and market dynamics. This can be challenging for new or inexperienced crypto options traders. Concepts like the Option Greeks (Delta, Gamma, Theta, Vega, and Rho), implied volatility, and various options strategies require significant study and practice to master.

The learning curve can be steep, and mistakes can be costly. New traders must invest time in education and potentially start with paper trading or small positions to develop their skills before committing significant capital to options trading.

Transaction Costs

Buying and selling put options involve transaction costs, such as commission and fees. These costs can erode gains, especially for repeated and rapid options trades. Unlike spot trading where you might pay a simple trading fee, options trading often involves multiple fee components including exchange fees, clearing fees, and broker commissions.

For active traders who frequently open and close positions, these costs can accumulate quickly and significantly impact overall profitability. It's essential to factor in all transaction costs when calculating potential returns and to ensure that your trading strategy can remain profitable after accounting for these expenses.

Put Options vs Call Options

So far, we've explored the world of put options. Now, let's delve into the opposite side of the spectrum: call options. Unlike puts, which give you the right to sell an asset at a specific price, call options grant you the right to buy an asset at a predetermined strike price before the expiration date. Both types have an expiration date and require a premium payment upfront.

While they share similar structural characteristics and risks, their strategies are fundamentally reversed. Both require the underlying asset's price to reach a certain level and move beyond it for profitability. However, price direction is key here: puts benefit from a price decline, while calls benefit from an increase. The magnitude and timing of this price movement also play crucial roles in determining the performance of your trade.

Call options are typically used by bullish traders who anticipate price appreciation, while put options are favored by bearish traders or those seeking portfolio protection. For example, if you believe Bitcoin will rise from $60,000 to $70,000, you would purchase call options. Conversely, if you expect a decline to $50,000, put options would be appropriate.

Both put and call options can be combined in various strategies to profit from different market conditions. Straddles involve buying both a put and call at the same strike price, profiting from significant price movement in either direction. Strangles use different strike prices for the put and call, reducing upfront costs while still capturing large price swings.

Put Options vs Short Selling

Another alternative to puts is short selling. This strategy is often referred to as "shorting" by experienced crypto traders and involves selling an asset you don't own with the intention of buying it back at a lower price. Essentially, you're betting that the price will decline. Unlike puts, short selling involves borrowing the asset from a broker or exchange at the current higher price, selling it immediately in the market, and then buying it back at a lower price to return it to the lender. This creates a gain from the price difference, minus any borrowing costs.

One key distinction between puts and short selling is the obligation to buy the underlying asset. With puts, you have the right but not the obligation to sell at the strike price. In short selling, you're obligated to buy back the asset to return it to the lender, regardless of the price. This fundamental difference creates vastly different risk profiles.

Short selling carries theoretically unlimited risk because there's no cap on how high the asset's price can rise. If you short sell Bitcoin at $60,000 and it rises to $80,000, you face a $20,000 loss per Bitcoin. With put options, your maximum loss is limited to the premium paid, providing a defined risk scenario that many traders prefer.

Additionally, short selling typically requires a margin account and involves borrowing costs that accumulate over time. Put options have no such ongoing costs beyond the initial premium. However, short selling doesn't suffer from time decay like put options do, meaning you can maintain a short position indefinitely (subject to borrowing availability and costs) without the pressure of an approaching expiration date.

While both puts and short selling can be used to make gains from a declining asset price, they share the risk of potential losses if the price rises unexpectedly. Given the long-term upward trend in crypto markets, these strategies are generally considered short-term tactical approaches rather than long-term investment strategies.

An Example of Put Options Trading

Let's now explore a practical trade you could consider taking if you're bearish and want to learn how to profit from declining Bitcoin prices. After conducting some basic technical analysis by referring to Fibonacci retracement levels and the relative strength index (RSI) indicator, we can observe that Bitcoin is approaching the 0.618 golden ratio Fibonacci retracement level, a key technical resistance point. Meanwhile, the RSI reads 63 and is quickly approaching the overbought level of 70. Based on these two technical factors, it might hint that a possible near-term pullback is coming.

To capitalize on this anticipated short-term correction, we can examine the BTC options chain and consider buying BTC puts that are two weeks to expiry. This timeframe provides sufficient duration for the expected pullback to materialize while minimizing the cost impact of time decay. Strike price wise, we can consider targeting a pullback to the $61,000 level since this aligns with approximately the 0.5 Fibonacci retracement level, a common support area.

This specific put option might cost you about 0.0218 BTC in premiums for the Bitcoin put contract with a $61,000 strike price. If this OTM put contract ends up ITM as Bitcoin prices decline to $61,000 or below within the two-week timeframe, you'll be able to reap substantial gains. At expiry, if Bitcoin trades at $61,000, your put option would have intrinsic value, giving you the option to sell one Bitcoin at $61,000 even if the market price has fallen further.

For example, if Bitcoin drops to $58,000 by expiration, your put option would be worth $3,000 in intrinsic value (the difference between the $61,000 strike price and the $58,000 market price). After deducting your initial premium cost of approximately $1,300 (0.0218 BTC at $60,000 per BTC), your net profit would be around $1,700, representing a return of over 130% on your premium investment.

This example illustrates how technical analysis can be combined with options trading to create strategic trades with defined risk and substantial profit potential. However, it's important to note that if Bitcoin continues rising or remains above $61,000 at expiration, the put option would expire worthless, resulting in a total loss of the premium paid.

Final Words and Next Step

Traders worldwide use puts to anticipate price declines in various assets, from cryptocurrencies to stocks and commodities. As such, for newcomers to options trading, understanding puts is crucial for developing a comprehensive trading toolkit. Puts can effectively serve as a hedge for those already holding a specific asset, providing downside protection during market corrections, and double as a way to speculate on price drops with defined risk parameters. This versatility makes put options a valuable tool for traders across different markets and experience levels.

However, like any form of trading, dabbling with put options comes with inherent risks that must be carefully managed. The most significant risk is the potential for an unexpected market turn. If your prediction is incorrect and the underlying asset's price rises instead of falls, you could incur losses equal to the premium paid. Fortunately, the lack of obligation to exercise a put option limits your potential loss to the premium paid, providing a clear risk boundary that helps with position sizing and risk management.

Before engaging in put options trading, it's essential to thoroughly educate yourself on option mechanics, pricing models, and the various factors that influence option values. Consider starting with paper trading or small positions to gain practical experience without risking significant capital. As you develop proficiency, you can gradually increase position sizes and explore more advanced strategies that combine puts with other instruments to create sophisticated risk-reward profiles tailored to your trading objectives and market outlook.

FAQ

What is a Put Option? What is its basic principle?

A put option gives the holder the right to sell an underlying asset at a predetermined price. Its basic principle is profiting when the market price falls below the strike price. Put option buyers benefit from price declines.

How to buy put options? What conditions and steps are needed?

Open a futures trading account, select put option contracts matching your market outlook, ensure sufficient margin, and place orders. Consider expiration dates and strike prices carefully before executing trades.

How much does it cost to buy put options? What factors influence the price?

Put option costs vary from a few dollars depending on factors like underlying asset price, expiration time, strike price, and market volatility. Lower stock prices and longer expiration periods typically increase option premiums.

What are the risks of put options? What is the maximum loss?

The maximum loss for buying put options equals the premium paid upfront. Risk occurs when the asset price rises above your strike price, making the option worthless and losing your entire premium investment.

What is the difference between put options and call options?

Call options give holders the right to buy an asset at a specific price, expecting price increases. Put options give holders the right to sell at a specific price, expecting price declines. They are inverse strategies for different market outlooks.

When should you use put options for hedging or investment?

Use put options when you expect asset prices to decline. They provide downside protection and profit from price drops. Ideal for hedging existing positions or speculative bearish trades during market downturns.

How to Calculate Put Options Profit and Loss?

Put option profit formula: Profit = (Strike Price - Asset Price at Expiration) × Contract Quantity. When asset price falls below strike price, the option gains value. Maximum profit equals strike price minus premium paid. Maximum loss is the premium paid for the option.

Where can I trade put options?

Put options can be traded on major cryptocurrency exchanges and futures brokers offering derivatives trading. Platforms providing put options include established exchanges with options markets, futures platforms, and specialized options brokers. Check if your preferred broker supports put option trading.