Chapter 16: How to Choose the Right Put Option

Book: Understanding Options 2E

Type: Chapter 16

Difficulty: Beginner

Reading time: 12 min

Core idea

A put is the right to sell at the strike

When you buy a put, you purchase the right — not the obligation — to sell 100 shares of the underlying stock per contract at a fixed strike price, any time before expiration. Mechanically, a put is the mirror image of a call: where a call buyer profits when the stock rises, a put buyer profits when the stock falls. The further and faster the underlying drops below the strike, the more valuable the put becomes.

Trading desks at the CBOE have a saying: “Puts are your friend.” Many retail investors ignore puts entirely because they have been conditioned to “go long and stay long.” That blind spot leaves them with only one tool — the buy-and-hold long position — when markets present three regimes (bull, flat, bear). Knowing how to use puts means you have something to do in all three.

Moneyness reads backwards for puts

A put is in the money when the strike is above the stock price (you have the right to sell high), and out of the money when the strike is below the stock price (you have the right to sell low — economically useless). This is the inverse of calls, and option chains for puts can look “upside down” until your brain re-anchors:

• In-the-money (ITM) put — strike > stock price. Has intrinsic value. More expensive.
• At-the-money (ATM) put — strike ≈ stock price. All premium is time value.
• Out-of-the-money (OTM) put — strike < stock price. Cheap, low probability.

Why it matters

Two distinct reasons to own a put

The mechanics are identical, but the intent — and the position sizing — differs sharply between the two main use cases.

1. Speculation. You believe a stock or index is going down. Buying puts gives you defined-risk downside exposure: your maximum loss is the premium paid. Compared with shorting the stock, puts require less capital and carry no theoretical unlimited loss. The trade-off is the same triple-correct burden as buying calls — direction, magnitude, and timing must all align.

2. Insurance / hedging. You own a stock or portfolio you want to keep — for tax reasons, dividend access, or long-term conviction — but you’re worried about a near-term drawdown. Buying puts on your position (or on a related index ETF) creates a price floor. The puts increase in value as the stock falls, offsetting the unrealized loss on the long position. This is sometimes called “disaster insurance.”

Puts are safer than shorting

Selling a stock short obligates you to buy it back later. If the stock unexpectedly doubles, your loss is unbounded — there is no theoretical cap on how high a stock can go. Buying a put has a hard floor: the most you can lose is what you paid. For most retail investors, expressing a bearish view through puts is structurally safer than shorting.

The cost of that safety is the premium. Puts can be expensive — especially in volatile, falling markets when implied volatility spikes. But the buyer’s risk is known before they click submit.

Key takeaways

Key takeaways

• A put gives the right to sell 100 shares at the strike price — profits grow as the underlying falls below the strike.
• Moneyness for puts is inverted: ITM = strike above stock; OTM = strike below stock.
• Buying puts is structurally safer than shorting — maximum loss is the premium paid, no margin call risk.
• Two reasons to buy puts: speculation on a decline, or insurance against a position you want to keep.
• Breakeven for a long put = strike − premium paid; the stock must fall below this line to profit at expiration.
• When stocks are bullish, buy calls; when flat, sell covered calls; when bearish, buy puts. Three tools, three regimes.

Mental model

click to zoom

The put-buyer's decision space and payoff

Read it as: The first fork is intent — are you speculating or hedging? Speculative puts face the same strike trade-off as calls, with slightly-ITM as the prudent default. Hedging puts have a different logic: pick the strike that defines an acceptable floor for the stock you already own, and treat the premium as an insurance cost rather than a directional bet.

Practical application

1. Define your intent first — speculation or insurance? The two use cases call for different strikes and different sizing.
2. Identify weak underlyings for speculation — stocks trading below their 50- or 200-day moving averages, those that have rallied too far too fast, or sectors hit by macro headwinds.
3. For speculation, default to slightly-ITM puts — they have intrinsic value and decay more slowly than OTM puts. Resist the cheap-OTM lottery temptation.
4. For hedging, match strikes to your pain threshold — if you can tolerate a 10% drawdown but no more, buy puts struck roughly 10% below the current price. They cost less than ATM puts and cover the catastrophic-tail scenario.
5. Calculate breakeven — strike − premium = breakeven. For a $90 strike put bought at $3.80, breakeven is $86.20.
6. Size the hedge sensibly — one put contract hedges 100 shares. If you own 250 shares, two contracts under-hedge slightly; three over-hedge. Round to the share count, not your fear level.
7. Mind implied volatility — IV often spikes during market drops, making puts expensive just when you want them. Better to buy modest insurance during calm periods than panic-buy puts mid-crash.

Trade both sides

A trader who only knows how to go long has one tool and three market regimes to deal with. Add covered calls for flat markets and long puts for declines, and your kit matches the market’s behavior — not just one slice of it.

Example

Same drop, three ways to express the view

Suppose Alex believes a tech stock at $200 is overvalued and likely to fall to $175 within two months. Three ways to express that view:

Option A — Short 100 shares of the stock. Requires ~$10,000 margin. If the stock falls to $175, profit is $2,500. If the stock unexpectedly rallies to $250 on an acquisition rumor, loss is $5,000 — and theoretically unlimited if the rumor turns into a buyout at $300.

Option B — Buy 1 OTM put, $185 strike, two months out, $2.20 premium. Total outlay $220. Breakeven $182.80. If the stock falls to $175, the put is worth ~$10 intrinsic — profit $780 on $220 = 354%. If the stock stays flat or rises, max loss is $220. Huge percentage upside, but the move must actually happen.

Option C — Buy 1 slightly-ITM put, $205 strike, two months out, $8.50 premium. Total outlay $850. Breakeven $196.50. If the stock falls to $175, the put is worth ~$30 intrinsic — profit $2,150 on $850 = 253%. If the stock stays flat at $200, the put still has $5 intrinsic at expiration — loss is only $350 (41%), not 100%.

Same thesis, three risk-reward profiles. Option A maximizes dollar exposure but introduces uncapped loss. Option B maximizes percentage upside at the cost of a higher chance of total loss. Option C trades some explosive upside for a structural cushion that survives a modest stall. The “right” answer depends on conviction — but only the put strategies let Alex sleep through a $300 acquisition rumor.

Related lessons

Related

Chapter 15: Exercise: Your Right to Buy The call-side counterpart to expiration mechanics — puts work the same way, just inverted. Chapter 11: How to Choose the Right Call Option Strike-selection logic that maps almost directly onto puts, with moneyness reversed. Understanding Options 2E — Book overview Return to the book index for the full chapter map and learning path.