What is a Put Option?

Published by Thomas Herold in Investments, Trading

'Put Option' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Put options are financial contracts that are entered into by two parties, the buyer of the option and the seller, or writer, of the option. They are generally called simply puts. A purchaser is able to establish a long position in a put option by buying the right to actually sell the instrument that underlies the put.

This is done at a particular price called the strike price and is only valid with the options’ seller for a certain amount of time. Should you as the buyer of the option choose to exercise your rights, then the seller has to purchase the associated instrument off of you at the price that was set in advance, whatever the present market price proves to be. In consideration for the buyer gaining this option, you pay an option premium amount to the seller of the option.

Put options are a form of insurance against loss. This is because they offer a guaranteed price and purchaser for a given amount of time for an associated instrument. Put option sellers also benefit when they obtain profits for selling you options that you do not choose to exercise. Options are almost never exercised if the instrument’s market value stays above the strike price within the put option contract time frame.

You as a buyer of a put option also have the ability to make money. This is done by selling the associated instrument for a higher price and buying back the position for a significantly lower market price. When an option is not sold or exercised, it expires worthless, representing a total loss of the premium paid for it.

When you purchase a put, you do so with the idea that the associated asset price will decline by the expiration date. The other reason for taking on such a put option is to safe guard a position that you own in the asset or security. Purchasing a put option provides an advantage as compared to selling a stock short. The most that you can lose with a put option is the money that you have paid for it, while those who sell short have an unlimited loss potential. The downside to a put is that the gain potential is restricted to a certain amount. This turns out to be the strike price of the option minus the spot price of the associated asset and the premium that you pay for the option.

A seller or writer of a put feels confident that the associated asset price will go up or remain the same but not decline. Sellers of puts engage in this activity in order to collect premiums. A writer of a put has a limited loss equal to the strike price of the put minus the spot price and the premium that has already been obtained. Put options can similarly be utilized to reduce a risk in the option seller’s investment portfolio. They can be part of complicated strategies called option spreads.

A put option that is not covered by owning the underlying security or asset is referred to as a naked put. In these types of put scenarios, the investor might hope to build up a position in the stock that underlies the options so long as they can get a cheap enough price. If you the buyer do not exercise these options, then the seller of the put gets to keep the premium that you paid for the option, representing a profit to the seller.

Should the associated stock’s actual price be lower than the strike price of the option when the expiration date comes, then you as a buyer have the ability to exercise the put option in question. This makes the seller of the put option purchase the associated stock at the strike price of the option. You as a buyer would profit to the amount of the difference found between the market price of the stock and the strike price of the option. Yet, should the price of the stock prove to be higher than the strike price of the option on the expiration day, this option becomes worthless. The loss to the owner of the option is restricted to the money that you paid for it, which then becomes the profit to the put option seller.

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The term 'Put Option' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.