The term put option refers to a financial contract that gives the investor the right to sell a security at a specified price before the agreement expires. A put option is not an obligation to sell the security; it merely provides the holder with the right to sell it.
Also referred to as simply a put, a put option is an arrangement between two parties that provides the holder with the right to sell an agreed-to number of securities at a specified price, and within a given timeframe. Put options typically involve securities such as stocks and bonds, as well as commodities.
The seller of a put option is referred to as the writer; they are obligated to buy the securities from the holder of the put option if they exercise their right. The buyer of a put pays a fee, known as a premium, to own the right to exercise their option. Every put option has at least three important features the buyer needs to be familiar with:
- Premium: this is the cost the buyer of the put pays to hold the option. It is also the price received by the writer.
- Strike Price: also known as the exercise price, this is the cost of the security if the holder of the put decides to exercise their right to sell it.
- Expiry Date: this is the date the option expires if the holder decides they don’t want to exercise their right to sell the security.
A put option that is in-the-money has real value to the investor. This happens when the strike price is above the current market price of the underlying security. Generally, the buyer of a put option is bearish on the security, since they believe the price of the security will decrease over time. The writer of the put option has a bullish view. They write the option because they believe the price of the security will increase over time.
Company ABC’s stock is currently trading at $10.00 per share. An investor believes this stock is overvalued, so they purchase a put option for 100 shares of stock with a strike price of $10.00, expiring in one month. The premium was $0.50 per share, so the investor paid $0.50 x 100 shares, or $50.00, for the put option. Three weeks later, the price of Company ABC’s stock decreases to $8.00 and the holder of the put decides to exercise their right to sell 100 shares of stock. The holder immediately buys the stock for $8.00 (if it is a naked put) and sells it for $10.00. The profit realized by the investor in this example would be:
= Market Price of Stock – Purchase Price – Premium = $10.00 x 100 shares – $8.00 x 100 shares – $50 = $1,000 – $800 – $50, or $150