A put option is a type of derivative that gains in value when the underlying stock moves lower. In other words, put options can be used to profit from a stock's decline -- somewhat akin to a short-selling strategy, albeit with a more conservative risk profile. While put options are most commonly regarded as bearish trading vehicles, experienced option traders can also combine puts with other types of contracts to construct a number of different bearish, bullish, and directionally neutral trading strategies.
In a plain-vanilla strategy, however, a bearish trader will buy to open a put option(s) on a stock he or she expects to decline during the life span of the option. This put option affords the trader the right to sell 100 shares of the underlying stock at the strike price of the contract, should the shares fall below the strike prior to the option's expiration date.
The initial premium paid to acquire the put option is also the maximum potential loss on the trade, which will be realized if the stock remains at or above the strike price through expiration. This is one major difference between buying a put and selling a stock short, as unhedged short sellers face theoretically unlimited losses on a move higher by the shares.
A put option is "in the money" when the price of the underlying stock is below the strike price of the option. An in-the-money put can be exercised by the holder in order to sell the shares at a premium to the current market price. Alternately, the contract can be sold to close before it expires, in which case the trader would profit purely from the increase in the option's value.
If an in-the-money put expires without being exercised or sold to close, it may be exercised on behalf of the holder by the Options Clearing Corporation (OCC). This process is automatic for any options that are in the money by $0.01 or more, unless alternate instructions are provided by the option holder. To avoid any unpleasant surprises at expiration, be sure to explore your closeout alternatives with your broker prior to buying a put option.