What Is a Put Option?

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Most investors choose investments in the hopes that they'll rise in value. Yet sometimes, you might be convinced that a stock is destined to go down. For those situations, using a put option can be the key to unlocking huge profit potential. In other cases, put options can help you reduce the risk of other positions in your investment portfolio. Let's take a closer look at what a put option is and when you might want to think about choosing put options.

What a put option isWhen you buy a put option, you get the right to sell stock at a certain fixed price within a specified time frame. Most put options allow you to sell 100 shares of stock to the investor who sells you the put option, and you have to make a decision about what to do before the option expires. If the price of the stock on the open market falls below what's called the strike price -- the specified price in the put option -- then you'll usually want to exercise the option and sell the stock at the higher strike price. Conversely, if the market price of the stock is still above the strike price of the put option, then you'll simply let it expire, and if you want to sell the stock, you'll do it on the open market where you'll get a higher price.

As you can see, put options are nice because they offer a way to profit from a stock dropping. If you own that stock, then buying a put option protects you from losses below the strike price, as you can always just exercise the option and guarantee that you'll get the fixed amount specified in the option. Yet buying a put option has an advantage over selling the stock you own outright, as you can still benefit from share-price increases. If you don't own the stock, on the other hand, then having a put option can actually help you profit from a decline in the stock price.

How put options can be profitable for you To understand how put options work, it's helpful to look at an example. Say you own 100 shares of a stock that trades at $103 per share, and you're concerned that it might decline in the near future. You could sell your stock, getting $10,300. You could also buy a put option that would give you the right to sell your stock at $100 per share any time in the next two months. Based on current market prices, we'll assume that the option would cost $1.50 per share, or a total of $150.

If you're right and the stock goes down to $80 per share by the time the option expires, then you can see how well each strategy works. Obviously, selling the stock gets you your $10,300 upfront. With the put option, you'd exercise it and sell your stock for $100 per share, ending up with $10,000 less the $150 you paid for the option, or a total of $9,850 -- which is still better than the $8,000 you'd get without the put option.

One problem with put options is that if the stock doesn't fall very far, you can end up missing out on any profits. For instance, if the stock in the example above only drops to $100 per share, you'd be $300 better off by having sold the stock, but you'd lose your entire $150 if you had bought a put option.

Interestingly, the usefulness of the put option as a defensive measure is most obvious when your concerns about the stock prove unjustified. If the share price rises to $120 per share, then having sold the stock will mean that you've missed out on an extra $1,700 in stock gains. But with the put option, you can never lose more than the $150 you paid upfront -- potentially saving you from missing out on big gains in an unexpected advance.

By contrast, simply buying a put option without owning the underlying stock works out best when the stock falls. That's because you don't have the losses from your position in the stock offsetting the gains in the value of the put option, and so you're able to reap the full benefits of the put option's profits. In the first example above, if the stock falls from $103 to $80, the value of the put option would rise from $150 to $2,000, and since you don't own the stock, you avoided the $2,300 drop in the value of a 100-share position. You could clear a $1,850 profit just by selling the put option before it expires.

Put options are a useful tool either to help manage risk in your portfolio or to make bets on a stock you don't own falling. In many cases, using a put option can give you more flexibility and a more attractive potential return than other strategies.

The article What Is a Put Option? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.