A put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option. Put options are traded on various underlying assets such as stocks, currencies, and commodities. They protect against the decline in the price of such assets below a specific price.
With stocks, each put contract represents 100 shares of the underlying security. Investors do not need to own the underlying asset for them to purchase or sell puts. The buyer of the put has the right, but not the obligation, to sell the asset at a specified price, within a specified time frame.
The seller has the obligation to purchase the asset at the strike/offer price if the option owner exercises their put option.
Buying a Put Option
Investors buy put options as a type of insurance to protect other investments. They may buy enough puts to cover their holdings of the underlying asset. Then, if there is a depreciation in the price of the underlying asset, the investor can sell their holdings at the strike price. Put buyers make a profit by essentially holding a short-selling position.
The owner of a put option profits when the stock price declines below the strike price before the expiration period. The put buyer can exercise the option at the strike price within the specified expiration period. They exercise their option by selling the underlying stock to the put seller at the specified strike price. This means that the buyer will sell the stock at an above-the-market price, which earns the buyer a profit.
Assume that the stock of ABC Company is currently trading at $50. Put contracts with a strike price of $50 are being sold at $3 and have an expiry period of six months. In total, one put costs $300 (since one put represents 100 shares of ABC Company). Assume that John buys one put option at $300 for 100 shares of the company, with the expectation that the ABC’s stock price will decline. The stock price is expected to fall to $40 by the time the (put) option expires.
If the price does drop to $40, John can exercise his put option to sell the stock at $50 and earn 100 shares times $10 – $1,000. His net profit is $700 ($1000 – $300 option price]. However, if the stock price remains above the strike price, the (put) option will expire worthless. John’s loss from the investment will be capped at the price paid for the put.
Selling a Put Option
Instead of buying options, investors can also engage in the business of selling the options for a profit. Put sellers sell options with the hope that they lose value so that they can benefit from the premiums received for the option. Once puts have been sold to a buyer, the seller has the obligation to buy the underlying stock or asset at the strike price if the option is exercised. The stock price must remain the same or increase above the strike price for the put seller to make a profit.
If the price of the underlying stock falls below the strike price before the expiration date, the buyer stands to make a profit on the sale. The buyer has the right to sell the puts, while the seller has the obligation and must buy the puts at the specified strike price. However, if the puts remain at the same price or above the strike price, the buyer stands to make a loss.
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