What is a Put Option?
A put option is an options 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) and at a predetermined expiration date. It is one of the two main types of options trading, with the other type being call option. Put options are mainly traded on different underlying assets such as stocks, currencies, and commodities, and they protect against the decline in the price of such assets below a specific price.
Each put contract represents 100 shares of the underlying security, and investors do not need to own the underlying asset for them to purchase or sell puts. In a scenario when the price of stocks or commodities falls below the specified price, the owner or buyer of the put has the right, but not the obligation, to sell the assets at a specified price and within a specified time frame.
On the other hand, the seller has the obligation to purchase the asset at the strike/offer price as long as the owner has the right to exercise the put option. The owner of the put receives compensation for the asset that is equal to the strike price, regardless of the value of the underlying asset.
Buying a Put Option
Investors buy put options as a type of insurance to protect their assets. They buy enough puts that cover their holdings of the underlying assets such that, if there is a depreciation in the price of the underlying assets, the investor can sell their holdings at the strike price. Put buyers expect the price of their underlying assets to decline, and the options allow them to make a profit instead of short-selling their stock holdings.
The owner of a put option expects to profit when the stock price declines below the strike price before the expiration period. In such a scenario, the owner of the put has two options. The buyer can exercise the option (without selling the underlying asset) at the strike price within the specified expiration period.
The other option is to exercise the contract by selling the underlying stock to the put seller at the specified strike price. It means that the buyer will sell the stock at an above-the-market price, which earns the buyer a profit. However, if the strike price is equal to or above the stock price, the buyer will make a loss if he/she decides to sell the put option.
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 in the next few months. The stock price is expected to fall to $40 by the time the (put) option expires.
Selling the stock will earn John $5,000 ($50 x100 shares) upfront. With the put option, John can exercise it and sell the stock for $40 per share and earn $4,000. With the fall in ABC Company’s stock, John will earn a net profit of $700 [$5,000 – $4,000) – $300]. However, if the stock price remains above the strike price, the (put) option will remain worthless and John’s loss from the investment will be capped at the price paid for the put.
Selling a Put Option
Instead of buying put options, investors can also engage in the business of selling the options for a profit. Put sellers sell put options with the hope that they lose value so that they can benefit from the premiums. Once puts have been sold to a buyer, the seller has the obligation to buy the underlying stock or asset at the strike price before the expiration date. The seller must have ready capital to purchase the puts from the buyer. 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. The seller can decide to keep the premium and sell the puts to another buyer.
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