What are Put Options?

Put options are contracts between a trader (buyer) and a seller of an option, in which the trader/buyer has the right to sell an underlying asset at a specific price and within a specific period. The buyer is not obligated to exercise the option. It is obligatory for the seller (option writer) to buy the asset at the strike price from the buyer/trader, should the trader decide to exercise the option.

In simple terms, a put is a “sell” option trade, in which the trader makes money when the price of the asset falls below the strike price.

All options contracts have a buyer and seller. The seller, also known as the option writer, has the obligation to buy off a put on an asset from the buyer/trader at a specified price (strike price) and by a specified date (the expiration date). The trader has the right, but not the obligation, to complete the transaction on the expiration date.

Trade Example

For this trade example, we have a trader who wants to purchase a put on stock XY, which is trading at $50 a share. The current price of XY is $55 per share, and the trader purchases a standard put option contract worth $5 per share on this stock. This contract will cost the trader $500.

Scenarios

If the price of XY falls to $40 just before expiration of the put option, the trader can exercise the put option because the conditions are favourable. The trader can buy 100 shares of XY for $4,000, and sell them to the put option writer at $5,000 (i.e. 100 shares at the strike price of $50). The trader will make $1,000 from the exercise of this put option contract, but the cost of the contract ($500) will be deducted to give him a net profit of $500.

Total earnings = ({$5000 – $4000} – $500) = $500

If the price of XY stays at, or is above the strike price of $50, the conditions for profiting from exercising the option will not exist, since it will be more expensive to buy the stock from the stock market. In this case, the trade is effectively out-of-the-money, and it is a question of the trader limiting the losses. He will therefore not exercise the option, and choose instead just to lose the premium he paid on the put option contract, which is $500.

Considerations

The put option can be used both as a speculative vehicle of investment, and a hedge trade. As a hedge trade, the put option is used to hold an opposite position to that held in a stock so that if there is an adverse movement in the price of a stock in the stock market, the put option can protect against those losses in the options market.

As in other options trade types, the trader must analyse the underlying asset properly in order to get his trade right. If the trader is able to get this right, then he will smile to the bank on payday.








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