What is a Put Option?
A put option is a contract agreed upon between two parties; the writer of the contract (referred to as the seller) and the buyer of the option agreement. In a put agreement, the buyer acquires a short position of the underlying asset by purchasing the right to sell the underlying instrument to the seller of the option at a specific price, known as the strike amount.
If the buyer of the option exercises their right, the seller is then obligated to purchase the underlying instrument from the buyer at the agreed-upon strike price, regardless of the current market price. In exchange for possessing this option, the buyer then pays the seller or writer of the option a fee, referred to as the option premium.
By providing a guaranteed buyer and price for the underlying asset, put options offer insurance against severe risk and excessive loss.
Sellers of put options will profit by selling options that are not exercised. This is the case when the ongoing market value of the underlying instruments makes the option unnecessary, meaning the market value of the instrument remains above the strike amount during the option contract period.
A purchaser of a put option may also profit through the ability to sell the underlying asset at an inflated price relative to the current asking price of the asset; as a result of this relationship the owner of the put option may repurchase their position in the equity at the reduced current market price.
Examples of a Put Option
A buyer who purchases a put believes that the price of the underlying stock will decrease in value. The individual pays a premium which will never be recouped unless the put option is sold before the contract expires. The buyer has the right to sell the stock at the exercise or strike price.
The writer of the put option receives the premium from the buyer. If the buyer exercises the option, the writer will repurchase the stock at the strike price. If the buyer does not exercise the option, the writer’s profit is the premium.
Trader Z purchases a put option to sell 100 shares of ABC Corp. to Trader Y for $50 per share. The current price of ABC Corp. is $55 per share and Trader A pays a premium of $5 per share. If the price of ABC Corp. falls to $40 a share before expiration, then Trader Z can exercise the put by purchasing 100 shares for $4,000 from the market then selling them to Trader Y for $5,000.
If the share price never drops below the strike price of $50, then Trader Z would not exercise the option. Trader Z’s option therefore would be worthless and the individual would lose the investment, which is the premium to purchase the option contract. Trader Z’s total loss is limited to the cost of the put premium plus the sales commission required to purchase it.z