Buying a Put Option…Explained!

Also see: one of the most common questions I receive.

In this post, I’m going to do my best to help you all understand what a put option is. In typical Farm Girl Next Door fashion, I’m going to do it with an analogy.

Here’s the formal definition: A put option gives the option holder the right, but not the obligation, to sell the underlying futures contract at the strike price by a certain date.

Ok, now for the analogy!

Let’s imagine you want to sell your house. With the current market, you are confident you could sell it today for $250,000. However, you’re not ready to sell yet. You want to wait until next year, but you’re worried about the market falling by the time you’re ready to sell.

Imagine that, for an investment, you could protect a selling price. Worst case scenario, you want to make sure it sells for at least $230,000. For $5,000, you could buy the option to sell the house with certainty for $235,000 by next year. Thus, after the $5,000 investment for that option, you’d net a selling price of $230,000.

Fast forward to next year when you decide to sell your house. Home values have increased and you can now sell it for $255,000.

Would you exercise the option you bought to protect a selling price of $235,000?

No, because why would you sell it for less than you can in the current market if you’re not obligated to? Remember, the option gives you the right, but not the obligation to sell at that price. In this case, you’d forfeit the $5,000 you paid to protect a selling price of $230,000.

Ok, now let’s imagine an alternative scenario. Instead of home values increasing, the housing market tanks. It’s next year and you can only sell the house for $220,000. In this case, you’re going to exercise your right to sell your house at $235,000 because that price is above the current market (Remember, you net a selling price of $230,000 after your $5,000 investment.)

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Now, let’s think of this in terms of corn and protecting a floor price by buying a put option.

Imagine you have corn in storage that you plan to deliver in June or July, and you want to protect a floor price.

Remember our housing example? You had the same goal: you weren’t ready to sell yet, but wanted to protect a floor price.

Today, July corn futures (CN21) are trading at $5.30.

An ‘at the money’ (i.e. at the current market) $5.30 put costs $.46. An out of the money put at $4.90 costs $0.25. Of course, there are other puts to purchase between those two and outside of that range. These are just two examples.

So, depending on what you want to spend and what price you want to protect, you could buy a put to protect a floor price.

For the sake of this example, let’s say you buy the $4.90 put for a $.25 investment.

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Let’s break it down:

Think of buying a put like an insurance policy. The $.25 is like your insurance premium. You hope you don’t have to use the premium, but if you do, you’re protected.

Let’s say you hold this put option until expiration on June 25, 2021. At expiration the market is trading below $4.90. It’s at $4.25. In this case, as the holder of a put option for $4.90, you have the right, but not the obligation to sell CN21 futures at $4.90, which is $.75 above the current market. Thus, your put is worth $.75 and you could exercise your right to sell CN21 at $4.90.

Your net price if you exercised the option would be $4.90 – $.25 investment = $4.65 (less any brokerage fees).

Now, let’s look at the alternative. At expiration, the corn market has continued to rally and CN21 is now trading at $5.75.

In this case, your put option expires worthless (i.e. you wouldn’t want to exercise your right to sell at $4.90 when the market is at $5.75). Thus, your investment of $.25 is not recouped. Again, think of it like your insurance premium. You invested in the put option for downward price protection, and while you don’t get the $.25 investment back, you still get to sell your corn at a higher market price since corn continued to rally. If you sold at $5.75, your net price would be $5.50 after the $.25 investment in the put option.

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Alright, so key takeaways:

Buying a put protects a floor price.

As the holder of a put option, you have the right, but NOT the obligation, to sell the underlying futures contract at the strike price.

Buying a put requires an investment, that you may or may not recoup depending on where the market trades. If the market is above the strike price of your bought put option at expiration, then your put option expires worthless.

Keep in mind, this is a super simplistic example to help get your mind wrapped around a put option. There’s plenty left out of this, but be on the lookout for more to come in future posts. 🙂