When buying a put option, a trader anticipates a drop in prices. For example, if you think “Y” ETF, which trades at $50, will fall over the next month, you would buy a put option. If the put option costs $1, the ETF would have to drop below $49 to generate a profit in this example. If you allow the option to expire, potential losses are limited to the cost of the option premium. Potential profits are not unlimited since it can only drop to $0.
Traders who write put options give someone else the right to sell the ETF at a specific price within a certain period in exchange for the option premium. Again, if you are not short the ETF, you are will write a “naked” put, which could result in huge losses. If the price rises, the premium helps offset losses on your short position. On the other hand, if the price declines, the trader only profits up to the point the buyer exercises their right to sell.
Paul Weisbruch at Street One Financial, who writes the “ETF Chart of the Day” series, also often discusses call/put activity in ETF options to get a handle on sentiment for various sectors. [Investors, Options Traders Turn Bearish on Small-Cap ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.