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What is a Put Option? Meaning.
A Put Option is an option that gives the buyer the right, but not the obligation, to sell the underlying stock, commodity, or other financial instrument at a set time and strike price from the writer (seller) of the put option. Normally, one option contract for a stock confers the right to sell 100 shares of the underlying stock.
The writer must buy the commodity or financial instrument should the buyer so decide. The purchaser pays a premium (a fee) for this right.
The purchaser of a put option expects the price of the commodity/instrument to decrease in the future; the writer expects that it will not, or he is willing to give up some of the upside (profit) from a price decrease in return for the premium plus still having the opportunity to make a gain up to the strike price.
A Put Option is a Derivative
Put and Call Options are derivatives of (other) financial securities since their values are intrinsically linked to and depend on the price of some underlying asset. Other derivatives include swaps, forwards and mortgage backed securities.
Merits of options trading. Pros
Disadvantages of options trading. Cons
Example of a Put Option
An investor may fear losses associated with his existing substantial investments in stocks (shares). His worries could be for a market crash or for the company to report very poor results. Our investor can purchase put options for say $1,000 in order to hedge his investments from these risks.
Suppose the stock value is $50.000 and the investor is willing to incur only 10% loss in the event of a major market failure. He can then buy put options giving him the right to sell at $45,000 (the agreed put option value) within some stipulated time frame.
In case the market indeed falls by a whopping 20%, the investor will benefit $5,000 because he is able to sell at $45,000 at the moment the stock is actually trading at $40,000.
To correctly calculate the total result of his investment, from that profit he will have to substract the Premium of $1,000 he had to pay in order to lock in that right. In case nothing special happens, the buyer of the put option loses only the fee of $1,000.
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This ends our Put Option summary and forum.
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