A put option is a contract that entitles the owner to sell a specific security, usually a stock, by a set date at a set price. The owner can either exercise the contract or allow it to expire, hence the term “option.” Options themselves are not a true security but rather a type of financial derivative, in that their value is derived from that of another asset. They can be bought and sold like stocks on derivatives exchanges and over the counter by financial institutions.
The mirror opposite of a put option is a call option, which gives the holder the right but not the obligation to buy a security at a set time at a set price. Both types of options allow the parties on each side of the trade to either take what's called a “long” position (betting on the possibility the stock will rise), or to take a “short” position (betting that it will fall).
In the case of a put option, the writer (i.e. the seller) is speculating that the stock will exceed expectations and the buyer is taking the chance it will underperform. This is not the same as short selling, in which an investor sells borrowed shares with the obligation to buy them back later to cover the position. But it presents another, potentially less risky way to take the bearish side in a trade because your losses are limited to the premium you paid for the put option vs. if you had sold the stock short your losses are in theory infinite, as the stock can go up indefinitely and you would be forced to buy back the shares at these prices.
Protective put strategy: The buyer of the option is essentially paying to offload risk. If a stock they hold goes down, they know they can sell that company at the value denoted on the option, known as the strike price. This way, they can limit their losses or lock in their gains on a holding. It sets a floor for the stock’s value up until the expiry date.
Covered put strategy: Where the writer of a put option owns a short position in the underlying stock (speculating that the company will decrease in value), the transaction is known as a "covered put strategy". If the stock goes down, their losses on the put contract will be offset by gains on their short position.
Naked put strategy: When the writer or seller of the put option has no position in the underlying shares, it is known as an uncovered or "naked put." They stand the risk of paying more than the market price to acquire the stock should the stock go down. The loss will be very substantial if the stock plunges toward zero.
The holder or buyer of a put option has no risk other than losing the premium they paid, because they are under no obligation to exercise the option.
A put spread is a strategy that involves buying and selling put options on the same stock simultaneously, though not necessarily at the same strike price. In a bullish put spread, you would sell put options at the higher strike price and buy put options at a lower strike price. It is a suitable option strategy for generating premium income or buying stocks at effective below-market prices.
A bearish put spread works the other way around, generating a return when the stock declines. In both cases, the simultaneous purchase and sale of put options can limit the risk on the trade, in contrast to a naked put, which comes with greater risk.
Protective put or married put strategy: An investor buys a volatile stock they expect to go up. They can also buy put options as a kind of stop-loss strategy to sell the stock at an acceptable price in case an event doesn’t turn out as expected.
Naked put strategy: A fund manager may write puts to generate additional income from a portfolio at the same time as they accumulate holdings in securities they like.