Put Option

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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

  1. Investors can use options for speculation reasons, for example wagering on predictive directions of a stock.
  2. Options can be used to hedge financial risks like a decline in the market value of the underlying company or an overall stock market decrease/increase.
  3. Options can help investors to buy a stock for less than its current market value or sell it for more than its current market value.
  4. Investors can also benefit from a temporary "bear market" or dips in the price of the stock.
  5. Options can be used to increase an individual's investment income through financial leverage

Disadvantages of options trading. Cons

  1. Due to the speculative nature of options, this kind of investment decisions carries substantial risk of loss.
  2. Options can be quite harmful if used incorrectly, one has to understand options before making such investment decision.

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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Compare with: American-Style Option  |  European-Style Option  |  Call Option  |  Asian Option  |  Real Options  |  Futures Contract  |  Hedge  |  Warrant

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