Put option

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This article is about financial options. For put options in legal matters, see Option
(law).
A put option (sometimes simply called a "put") is a financial contract beteen to
parties, the seller (riter) and the buyer of the option! "he put allos its buyer the right
but not the obligation to sell a commodity or financial instrument (the underlying
instrument) to the riter (seller) of the option at a certain time for a certain price (the
strike price)! "he riter (seller) has the obligation to purchase the underlying asset at
that strike price, if the buyer e#ercises the option!
$ote that the riter of the option is agreeing to buy the underlying asset if the buyer
e#ercises the option! %n e#change for having this option, the buyer pays the riter
(seller) a fee (the premium)! ($ote: Although option riters are fre&uently referred to as
sellers, because they initially sell the option that they create, thus taking a long position
in the option, they are not the only sellers! An option holder can also sell his short
position in the option! 'oever, the difference beteen the to sellers is that the option
riter takes on the legal obligation to buy the underlying asset at the strike price,
hereas the option holder is merely selling his long position, and is not contractually
obligated by the sold option!)
(#act specifications may differ depending on option style! A (uropean put option
allos the holder to e#ercise the put option for a short period of time right before
e#piration! An American put option allos e#ercise at any time during the life of the
option!
"he most idely)knon put option is for stock in a particular company! 'oever,
options are traded on many other assets: financial ) such as interest rates (see interest
rate floor) ) and physical, such as gold or crude oil!
"he put buyer either believes it*s likely the price of the underlying asset ill fall by the
e#ercise date, or hopes to protect a long position in the asset! "he advantage of buying a
put over short selling the asset is that the risk is limited to the premium! "he put writer
Buying a put option ) "his is a graphical interpretation of the payoffs and profits
generated by a put option as seen by the buyer of the option! A loer stock price means
a higher profit! (ventually, the price of the underlying security ill be lo enough to
fully compensate for the price of the option!
Writing a put option ) "his is a graphical interpretation of the payoffs and profits
generated by a put option as seen by the writer of the option! +rofit is ma#imi,ed hen
the price of the underlying security e#ceeds the strike price, because the option e#pires
orthless and the riter keeps the premium!
does not believe the price of the underlying security is likely to fall! "he riter sells the
put to collect the premium! +uts can also be used to limit portfolio risk, and may be part
of an option spread!
[edit] Example of a put option on a stock
Buy a Put: A Buyer thinks price of a stock will decrease.
Pay a premium which buyer will never get back, unless
it is sold before expiration.
The buyer has the right to sell the stock
at strike price.
Write a put: Writer receives a premium.
If buyer exercises the option,
writer will buy the stock at strike price.
If buyer does not exercise the option,
writers profit is premium.
Buy a call: The buyer expects that the price may go up.
The buyer pays a premium that he will never get back.
!e has the right to exercise the option at the strike
price.
Write a call: The writer receives the premium.
If the buyer decides to exercise the option, then
the writer has to sell the stock at the strike price.
If the buyer does not exercise the option, then
the writer profits the premium.
*"rader A* (Put Buyer) purchases a put contract to sell -.. shares of /01 2orp!
to *"rader 3* (Put Writer) for 45.
6share
! "he current price is 455
6share
, and *"rader
A* pays a premium of 45
6share
! %f the price of /01 stock falls to 47.
6share
right
before e#piration, then *"rader A* can e#ercise the put by buying -.. shares for
47,... from the stock market, then selling them to *"rader 3* for 45,...!
Trader "s total earnings (S can be calculated at #$%%.
&ale of the '%% stock at strike price of #$% to Trader ( ) #$,%%%
(P
Purchase of '%% stock at #*% ) #*,%%% (!
Put +ption premium paid to Trader ( for buying the contract of '%%
shares , #$
-share
, excluding commissions ) #$%% ("

S#P$(!%"#&'()))$(&*()))%&'))#&'))
%f, hoever, the share price never drops belo the strike price (in this case, 45.),
then *"rader A* ould not e#ercise the option! (Why sell a stock to *"rader 3* at
45., if it ould cost *"rader A* more than that to buy it8)! "rader A*s option
ould be orthless and he ould have lost the hole investment, the fee
(premium) for the option contract, 45.. (5
6share
, -.. shares per contract)! "rader
A*s total loss are limited to the cost of the put premium plus the sales
commission to buy it!
"his e#ample illustrates that the put option has positive monetary value hen the
underlying instrument has a spot price (S) below the strike price (K)! 9ince the option
ill not be e#ercised unless it is "in)the)money", the payoff for a put option is
ma#:(K ; S) < .= or formally, (K ; S)
>

here :
+rior to e#ercise, the option value, and therefore price, varies ith the underlying price
and ith time! "he put price must reflect the "likelihood" or chance of the option
"finishing in)the)money"! "he price should thus be higher ith more time to e#piry, and
ith a more volatile underlying instrument! ?etermining this value is the central
problem of financial mathematics! "he most common method is to use the 3lack)
9choles formula! Whatever the formula used, the buyer and seller must agree on this
value initially!