How Is a Put Option Exercised?

What Is a Put Option?

A put option is a contract that gives its holder the right to sell a set number of equity shares at a set price, called the strike price, before a certain expiration date. If the option is exercised, the writer of the option contract is obligated to purchase the shares from the option holder. "Exercising the option" means the buyer is opting to take advantage of the right to sell the shares at the strike price.

The opposite of a put option is a call option, which gives the contract holder the right to purchase a set amount of shares at the strike price prior to its expiration.

How Put Options Work

There are a number of ways to close out, or complete, the option trade depending on the circumstances. If the option expires profitable or in the money, the option will be exercised. If the option expires unprofitable or out of the money, nothing happens, and the money paid for the option is lost.

A put option increases in value, meaning the premium rises, as the price of the underlying stock decreases. Conversely, a put option's premium declines or loses value when the stock price rises. Put options provide investors with a sell-position in the stock when exercised. As a result, put options are often used to hedge or protect from downward moves in a long stock position.

Example of a Put Option Transaction

Max purchases one $11 put option on Ford Motor Co. (F). Each option contract is worth 100 shares, so this gives him the right to sell 100 shares of Ford at $11 before the expiration date.

If Max already holds 100 shares of Ford, his broker will sell these shares at the $11 strike price. To complete the transaction, an option writer will need to purchase the shares at that price.

Max may realize a gain on the option if the price of Ford stock falls below the $11 strike price. In other words, Max is protected from the stock price falling below the $11 strike price of the put option. However, the actual gain is also dependent on how much Max paid (the premium) for the option. In other words, if Ford were to fall to $10 per share, but Max paid $2 per share for the option contract, the breakeven point would be $9 per share ($11 - $2). If Ford were to fall below $9 per share prior to expiry Max would make a profit.

Let's say the stock falls to $8 per share. Max would be able to sell 100 shares at $11 instead of the current $8 market price. By buying the option, Max has saved himself $300 (less the cost of the option), since he has sold 100 shares at $11, for a total of $1,100, instead of having to sell the shares at $8 for a total of $800.

Max could have sold his stock at $11 and not bought a put option. But he might have believed that the stock price could rise. He didn't want to sell the stock, but he did want protection in case the stock's price dropped. He was willing to pay the option premium for that protection.

Example of a Short Position Transaction

Now let's assume that Max does not actually own shares of Ford but has bought the $11 put, and the stock is currently trading at $8. He could purchase shares of Ford at $8 and then have the broker exercise the option to sell the shares at $11. This would net Max $300, less the cost of the option premium, fees, and commissions. 

If Max doesn't own shares, the option can be exercised to initiate a short position in the stock. A short position is when an investor sells the stock first with the goal of buying the stock or covering it later at a lower price. Since Max doesn't own any shares to sell, the put option will initiate a short position at $11. He can then cover the short position by buying the stock at the current market price of $8, or continue to hold the short position.

Initiating a short position requires a margin account with enough money in it to cover the margin on the short trade. A margin account is a brokerage account in which the customer borrows money or shares from the broker to finance a long (buy) or short (sell) position. The account is typically collateralized by cash or securities.

Investors should be careful with shorting stocks since a stock could potentially increase in price. If the stock price rises rapidly, many traders might cover their short positions by buying the stock to unwind their short trades. The rush of short traders into buying the stock could exacerbate the move higher in the stock's price–called a short-squeeze. 

Selling the Option

An alternative to exercising an option is to sell the option contract back to the market. Selling the option is both the easiest and the most commonly used method of closing an option position. In other words, there is no exchange of shares; instead, the investor has a net gain or loss from the change in the option's price.

For example, the $11 put may have cost $0.65 x 100 shares, or $65 (plus commissions). Two months later, the option is about to expire, and the stock is trading at $8. Most of the time value of the option has been eroded, but it still has an intrinsic value or profit of $3, so the option may be priced at $3.10. Max bought his option for $65 and can now sell it for $310.

In the scenarios above, you must consider the cost of the option premium ($65, in this case) to calculate the net advantage of exercising the option.

Benefits of Selling the Option

There are many benefits to selling an option, such as a put, before the expiry instead of exercising it. Option premiums are in constant flux, and purchasing put options that are deep in the money or far out of the money drastically affects the option premium and the possibility of exercising it.

Closing out a put trade by simply selling the put is popular because most brokers charge higher fees for exercising an option compared to the commission for selling an option. If you're considering exercising an option, find out how much your broker charges since it could impact your profits, especially on smaller trades.

Broker fees vary widely. If you're thinking of opening a trading account, make sure to compare different options brokers before getting started.

The Bottom Line

A put option is a contract that gives its holder the right, but not the obligation, to sell a number of shares at a specific or strike price before its expiration date.

To exercise options simply means that the holder of an option contract is using their right to buy or sell shares of stock under the terms of the options contract.

In the case of a put option, it is said to be exercised when the writer of the option contract is obligated to purchase the shares from the option holder (the one who has the option or right to sell).

Investors may choose to exercise a put option they own when the stock price is lower than the strike price. This means they can sell the stock at a higher price and immediately buy it back at a lower price.