What is a Put Option?

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Put options are somewhat the opposite of call options. Using puts, it is possible to invest and benefit from declines in the stock market or in individual stocks. When you buy a put, you are forecasting that the stock's price will fall in value before the put's expiration date.

Buying puts is often compared to shorting a stock. But, although they are both bearish positions, buying puts is quite different. In fact, buying a put can be better than shorting the stock itself because your risk is limited to the amount you paid for the put option. If the market falls, both trades would be profitable … but if the market rises, your risk in a short stock trade is theoretically unlimited.

The process of buying a put is relatively simple. Typically, you want to find a stock in a firm downtrend that you feel is likely to remain in a downtrend. Once you have selected your "bearish" stock, buying a put works the same way as buying a call.

The chart below shows the iShares Russell 2000 ETF (IWM) from September 2007 through February 2008. IWM had been stuck in a dramatic downtrend and, by mid-February, was bouncing back down from a resistance level at $73 after a brief rise in January. This was a great candidate to for a put trade.

Running through a very similar trade entry process to the one that I discussed in the lesson on call options, we would start with buying a put with a strike price closest to the current stock price. Since the stock was priced at $70.18 at that time, the 70 strike with about 30 days left before expiration looked like an ideal candidate.