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Put option
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A put option (sometimes simply called a "put") is a financial contract between two parties, the seller (writer) and the buyer of the option.
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Encyclopedia
A put option (sometimes simply called a "put") is a financial contract between two parties, the seller (writer) and the buyer of the option. The buyer acquires a long position offering the right, but not obligation, to sell the underlying instrument at an agreed-upon price (the strike price). If the buyer exercises the right granted by the option, the writer has the obligation to purchase the underlying at the strike price. In exchange for having this option, the buyer pays the writer a fee (the option premium). The terms for exercise differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.
The most widely-traded put option are on equities. However, options are traded on many other instruments such as interest rates (see interest rate floor) or commodities.
The put buyer either believes it's likely the price of the underlying asset will fall by the exercise date, or hopes to protect a long position in the asset. The advantage of buying a put over short selling the asset is that the risk is limited to the premium. The put writer does not believe the price of the underlying security is likely to fall. The writer sells the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread.
Example of a put option on a stock
Buy a Put:
A Buyer thinks price of a stock will decrease.
Pay a premium which buyer will never get back,
unless it is sold before expiration.
The buyer has the right to sell the stock
at strike price.
Write a put:
Writer receives a premium.
If buyer exercises the option,
writer will buy the stock at strike price.
If buyer does not exercise the option,
writer's profit is premium.
- 'Trader A' (Put Buyer) purchases a put contract to sell 100 shares of XYZ Corp. to 'Trader B' (Put Writer) for $50/share. The current price is $55/share, and 'Trader A' pays a premium of $5/share. If the price of XYZ stock falls to $40/share right before expiration, then 'Trader A' can exercise the put by buying 100 shares for $4,000 from the stock market, then selling them to 'Trader B' for $5,000.
Trader A's total earnings (S) can be calculated at $500.
Sale of the 100 stock at strike price of $50 to 'Trader B' = $5,000 (P)
Purchase of 100 stock at $40 = $4,000 (Q)
Put Option premium paid to Trader B for buying the contract of 100 shares @ $5/share, excluding commissions = $500 (R)
S=P-(Q+R)=$5,000-($4,000+$500)=$500
- If, however, the share price never drops below the strike price (in this case, $50), then 'Trader A' would not exercise the option. (Why sell a stock to 'Trader B' at $50, if it would cost 'Trader A' more than that to buy it?). Trader A's option would be worthless and he would have lost the whole investment, the fee (premium) for the option contract, $500 (5/share, 100 shares per contract). Trader A's total loss are limited to the cost of the put premium plus the sales commission to buy it.
A put option is said to have intrinsic value when the underlying instrument has a spot price (S) below the option's strike price (K). Upon exercise, a put option is valued at K-S if it is "in-the-money", otherwise its value is zero. Prior to exercise, an option has time value apart from its intrinsic value. The following factors reduce the time value of a put option: shortening of the time to expiry, decrease in the volatility of the underlying, and increase of interest rates. Option pricing is a central problem of financial mathematics.
See also
Options
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